ETFs and the currency effect

January 20, 2020

Canadian exchange-traded fund (ETF) assets continue to grow at an exponential rate. With over 800 ETFs now offered, Canadian investors have plenty of options to choose from. And with that wide a choice, choosing the correct investment criteria becomes even more challenging. One important criterion that is often overlooked by retail investors relates to currency risk.

ETFs that invest in non-Canadian-dollar assets can be exposed to fluctuations in the underlying currency. Thankfully, ETF sponsors typically offer multiple series that give investors a choice of how currency risk is handled. The three main types of series are Canadian dollar unhedged (CAD), Canadian dollar hedged (CAD-H), and United States dollar (USD). Due to the potentially large differences in performance of the various series, understanding how currency will impact returns is imperative when choosing an ETF.

Canadian dollar unhedged

When investing in an unhedged ETF, your investment can be exposed to currency risk. If investments in the fund are based in a different currency, your return will be affected by the change in value of this currency against the Canadian dollar. For example, iShares Core S&P 500 Index ETF Non-Hedged (TSX: XUS) is denominated in Canadian dollars, but the underlying investments are denominated in U.S. dollars. Therefore, the performance of this ETF is exposed to fluctuations in the U.S. dollar relative to the Canadian dollar.

If the U.S. dollar depreciates against the Canadian dollar, the returns of the ETF will be lower than that of the underlying index. Conversely, if the U.S. dollar appreciates against the Canadian dollar, the returns will be greater than the underlying index. Over the last year, the U.S. dollar has depreciated against the Canadian dollar, resulting in XUS underperforming the S&P 500 Composite Index by 7.3 percentage points.

Canadian dollar hedged

In a hedged ETF product, the portfolio manager uses complex derivative strategies to minimize the effect of currency fluctuations, so that the performance closely matches that of the underlying investments. Details of the derivative strategy may be found in the ETF’s prospectus and ETF Facts.

With the possibility of violent movements in foreign exchange markets, many investors would rather avoid exposure to currency risk. For example, Canadian investors may be looking for U.S. equity exposure while eliminating the currency risk between the Canadian dollar and the U.S. dollar. iShares Core S&P 500 Index ETF CAD-Hedged (TSX: XSP) does exactly that. This ETF seeks to replicate the performance of the S&P 500 Composite Index while minimizing the impact of changes in the USD/CAD exchange rate.

The effect on returns is clear. Units of XSP have a 1-year return of 29.2% as of Dec. 31, 2019, compared with the 31.5% for the underlying index. As you can see, the Canadian dollar-hedged ETF tracks its index very closely, despite a 4.8% drop in the U.S. dollar over the same period.

One thing to keep in mind is that hedged ETFs normally have slightly higher expenses than their unhedged sister funds due to the costs associated with hedging. However, this is a small price to pay for the protection these strategies can offer.

U.S. dollar

U.S. dollar-denominated ETFs are less common than the Canadian dollar hedged and unhedged versions, but still have benefits for certain investors. We have recently seen a resurgence of large ETF providers that have added a U.S. dollar option to their existing funds. It is obvious the popularity of this investment choice is on the rise, but it has a very specific use case.

Not to be confused with hedged ETFs, U.S. dollar ETFs are in fact denominated and held in U.S. dollars. That means most Canadians will have to make two foreign exchange transactions: first exchanging Canadian dollars to U.S. dollars for the initial purchase, and exchanging back again when the investment is sold. While not reflected in published performance figures, investors are still exposed to changes in the exchange rate between the two currencies.

This investment option usually makes sense only for Canadian investors who spend a significant amount of time in both countries and have U.S. dollar bank accounts. Fund companies may also be looking to entice American investors who are looking to invest in Canadian mandates. An investor south of the border might be more willing to invest if they are given the option of investing in their native currency.

Although studies suggest that the effect of currency fluctuations on returns is normalized in the long term, short-term movements can be severe, as shown in the accompanying graph, and may have undesirable consequences on returns.

To eliminate this risk, many Canadian investors opt for the stability and lower risk offered by Canadian dollar-hedged ETFs. Alternatively, some investors may welcome the currency risk associated with unhedged ETFs, perhaps taking a calculated bet on the direction of future currency movements.

The important thing is to understand what you are buying and the risks you are assuming. For a full list of Canadian ETFs, visit Fundata’s ETF database.

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