Wednesday, 30 May 2007

Clarification of Foreign Exchange Risk on International ETFs

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.


Canadian Capitalist said...

Even in the case of US equities, I am sceptical that the benefits of hedging are worth the cost (even if it is as low as 15 bps). Giant US companies themselves have sophisticated hedging programs to manage their overseas earnings. A report from Leith Wheeler asked this question: why do investors want a hedge on top of another?

My point is simple: why are investors interested in hedging after the bulk of appreciation has already occurred? It is so predictable that investors are fighting the last battle. This is not a prediction that the loonie is going to drop, simply that most of the appreciation has already taken place.

You are correct about the EFA and it is a common question in the comments. Hedging is even more questionable when a basket of currencies are involved. I switched XIN into EFA as soon as foreign content restrictions were relaxed.

FourPillars said...

Good explanation of how currency exposure works.

My attitude toward currency risk is that it is just another risk and diversifier of an investment portfolio which the investor should be aware of, and can manage if necessary.

As Canadian Capitalist has mentioned in his blog, over the long term (15+) years, currency swings should even out. For shorter time horizons I think currency hedging makes more sense however the best hedge for a short term investment is just to buy a Canadian dollar investment ie high-interest savings account.

There are many ways to alter the risk level of a portfolio and adding or subtracting currency hedging is just one of them.

Outroupistache said...

Cannot say I follow the Leith Wheeler point about US companies having already hedged their overseas earnings. So far as I understand that means they have removed the currency variation with respect to their home reporting currency the US$. But that doesn't remove the possible variation of the Canadian vs the US$, which is my worry as a Canadian investor.

The second part that puzzles me is why the US company's hedged earnings should matter much if at all. What concerns me as an investor is the stock market price of the shares/ETF. Is it suggested that the corporate hedging somehow translates directly into a different price in the market that compensates Canadian or other foreign investors?

I am not confident that the appreciation of the Canadian dollar vs the US$ has more or less done its thing. Our dollar is only now getting back to levels vs the US$ seen 30 years ago. That's a long time to wait for the evening out to occur. I haven't heard of a mean-reversion principle applying to currencies as it does to stock returns. Maybe the C$ will continue its upward climb for the next 30 years. I admit to not knowing.

Some of the stuff I've been reading to sort this out in my own head concludes, as FourPillars suggests, that the currency exposure is a good thing because it is a diversifier, making different parts of the portfolio move in opposition to each other at different times. So it may end up that I agree with you for different reasons.

Perhaps we need a North American version of the Euro to eliminate our problem ... the Neuro, or the Namo perhaps?

If it was too easy it wouldn't be fun, huh? said...

Investoid wrote an article yesterday on this exact US-Canadian exchange rate topic.

According to his graph, currency trends are measured in decade(s). Personally I don't hedge, but the jury is still out.

Paul said...

Great blog with some interesting comments.

I was wondering if given the recent gains being made by the loonie which is now nudging against US$1.06, if you agree that it would be prudent for Canadian Investors to increase their holdings of ETF's such as VGK, VPL, VEA or VWO? As you know these ETF's are traded in US$ but are based in different currencies and different non-American markets. As you mention the risk is 'the foreign currency of those companies and markets not the US$ despite the fact that VGK (for example) is bought and sold in the US'.

Surely, and forgive my naivety here, all a Canadian investor is really interested in is the fact that hopefully the value of the ETF in US$ increases and that the CAD devalues against the US$ when its time to sell and bring the cash back into Canada. Right now it would seem there is a rare opportunity for Canadian investors to buy US stocks as they are relatively cheap for us and I would include in that ETF's like VTI. But would this also be true when one is talking about ETF's like VPL etc which involve so many other currencies - are they still a bargain?

Thanks for your time and I look forward to your comments.

CanadianInvestor said...

From my perspective, yes, I agree that now is a time to buy many foreign equities, US and others, due to the appreciation of the Canadian dollar. But my reason and perspective is different from the one you state. Instead of a judgment as to whether those foreign equities are cheap I look at it from the viewpoint of the target portfolio mix.

I refer to my spreadsheet at the bottom of the blog, where my actual asset allocation structure (I'm too coy to reveal my total holdings) is laid out.

From that table, you can see that the allocation, as of now Friday, Nov.2 before markets open, indicates that I should sell a big chunk of VWO and Canadian fixed income, Canadian large cap XIU and I should buy VBR, VNQ, VBR, VPL, EFV, RWX and DJP.

It also shows I should sell a little bit of the hedged US large cap XSP and buy some of the unhedged VV to get back to my target asset allocation percentages ... huh, you say? I probably wouldn't do that since the net between the two is close to zero and what I am really after is a target investment in the US equity market not a target hedged vs unhedged, but it does illustrate the effects of the USD vs CAD currency shift.

I won't actually do the rebalancing to my target allocations till next May according to my policy to do it once a year.

The real problem with making a judgment about whether US stocks are cheap right now assumes two things: that the US market overall is cheap/undervalued and/or that the C$/US$ is over-valued and will go back down. Focusing just on the latter element, one must ask, how can one possibly know how much and when, within a span even of decades, the C$v US$ will go back down. It was 50 years ago that it was last so high. Maybe it will be another 50 years before before it goes back down to par. Maybe it will never do so. There is no long run average to which the exchange rate will tend to return. Long term exchange rates are heavily influenced by the economic success of countries. Was it inevitable that Chretien or someone else would come along and stop the slide into the quagmire of national debt? Is it inevitable that the US will stop its own current slide downwards or is it going the way of the Roman empire to be replaced by the Chinese? Other countries have demonstrated that it is possible to slide for a long, long time (Argentina) or to reverse fortunes from a long funk in a fairly short time (Ireland).

Ses also the comments of Michael Hill in question 11 of the Q&A interview in my blog post of Oct.23.

Bottom line: I believe in spreading things around (aka diversification) and varying my bet (allocation) in different markets not at all in the short term and according to proven success (reset my target allocations in keeping with the proportion of global market value) in the long term.

Thanks for the compliment!

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