Wednesday, 30 May 2007
There is a common misconception, under which I unfortunately found myself for a while, about the foreign exchange risk that one is accepting in purchasing international ETFs like Vanguard's European Equity Fund (ticker VGK). VGK trades on a US stock exchange and is paid for in US dollars. Its holdings are all in 603 different companies traded on European markets and are bought and sold in the currencies of local markets in Europe - Euros and Sterling mainly. As we all know, the Canadian dollar moves up and down against the US$, the Euro and the UK pound. The question is what exposure one has as a Canadian, or for that matter, as a foreigner from any country. Is it the US$ the trading currency only, the local company currencies only, or a mixture of both.
To explain this, I've created a simple example on the spreadsheet. The example uses real foreign exchange (FX) rates from today, taken from Yahoo. The second spreadsheet shows the table I used, though at a different time of day, so the rates won't be exactly the same as they change throughout any trading day.
Yahoo's FX table show the rates for major currencies. The thing to note, and as an illustration I did the arithmetic that proves this on my example spreadsheet, is that the rates all mesh. If one goes from US$ to Canadian$ and then on to UK£, it works out exactly the same as going direct from US$ to UK£. Rounding errors sometimes make the last digit different, as in my spreadsheet example, but in the real world any time there is a tiny discrepancy where it is possible to buy one currency and sell it through another to make a profit, that happens very quickly and the discrepancy disappears. The rates end up constantly aligned.
In my hypothetical, ultra-simplified portfolio of £100, the value at today's rate is CDN$212.28. In example 1, the C$ rate vs the US$ remains the same and rises vs the UK£. The portfolio value in C$ drops! In example 2, the C$ rate vs the US$ rises but is constant vs the UK£ and the portfolio value remains exactly the same! Add in the price changes of the investment and the simultaneous movement of all the currencies involved, the principle is still the same - a Canadian investor only is affected by changes between his/her own currency and the foreign currencies.
In short, the exchange risk I and others who have bought VGK are incurring is the foreign currency of those companies and markets not the US$ despite the fact that VGK is bought and sold in the US. There are international ETFs like XIN, the iShares Canada ETF that trades on the Toronto market, whose currency risk is being removed by the fund managers through trading in foreign exchange. XIN actually owns only one holding, shares of EFA, the ETF bought and sold in the US that tracks the Europe, Australasia, and Fare East MSCI index. XIN removes the currency effects of the EAFE countries not the US$.
VGK and other international ETFs like VPL (Vanguard's Pacific countries fund), VWO (Vanguard Emerging markets, including Russia, China, Korea, Brazil) expose investors to the combined proportional risks of those countries' currencies but not the US$.
Whether that currency exposure is good, indifferent or bad is still unclear to me. In my search for the answer, I've read variously that currency hedged portfolios give the same return as unhedged portfolios, that a certain proportion of the portfolio should be hedged (like 50 or 75% of the value of foreign holdings), or that the currency exposure provides another source of diversification benefit. That uncertainty is nevertheless not keeping from buying those foreign ETFs due to the powerful diversification benefits that international investing offers.
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