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On Oct. 12, 2019, Eliud Kipchoge became the first man to run 26.2 miles in less than two hours. He averaged a scorching 4 minutes 35 seconds a mile. Mr. Kipchoge wore a controversial pair of Nike shoes (since banned from competition), which add an extra bounce to every stride.

Innovation helps investors, too. Fewer people, for example, buy high-cost, actively managed mutual funds. Low-cost ETFs offer a far better option. But sometimes, attempts to innovate can get us running in hiking boots. Such is the case with currency-hedged stock-market ETFs.

They’re designed to smooth out currency fluctuations. It’s an attractive pitch. For example, assume the S&P 500 index of U.S. stocks gains 5 per cent in a year, measured in U.S. dollars. If the Canadian dollar rose 5 per cent against the U.S. dollar that year, an investor in a plain vanilla S&P 500 ETF wouldn’t make a penny, in Canadian-dollar terms. But if someone were invested in a currency-hedged S&P 500 ETF, they would earn 5 per cent in Canadian dollars, if the U.S. index gained 5 per cent.

At least, that’s the theory. But there are problems: First, currency fluctuations aren’t always bad. For example, if the U.S. index increased by 5 per cent (again, in U.S. dollars) and the Canadian dollar fell 5 per cent, then an investor in a non-currency hedged S&P 500 index would earn 10 per cent, in Canadian dollars.

Nobody can predict, with any degree of accuracy, how currencies will move. That’s why smart investors build globally diversified portfolios of non-currency-hedged ETFs. Proponents of currency-hedged products say they decrease volatility. However, a 2018 Vanguard study says otherwise. In a globally diversified portfolio of ETFs, they often increase volatility.

Raymond Kerzérho, a director of research at PWL Capital, says currency-hedged funds also carry high internal costs that hurt investment performances. He examined the returns of hedged S&P 500 indexes between 2006 and 2009. The funds were meant to mirror the index they were tracking, but they lagged by an average of 1.49 per cent a year. The currency-hedged iShares Core S&P 500 Index (XSP) has about $5-billion under management. Its performance in Canadian dollars is designed to match the performance of the index in U.S. dollars, after management fees – but it hasn’t come close.

According to Morningstar, the S&P 500 averaged a compound annual return of 9.04 per cent from January, 2005, to Dec. 31, 2019. But management fees and, far more importantly, the hidden friction costs of hedging meant XSP averaged a compound annual return of just 7.33 per cent. It lagged the index it was supposed to track by a whopping 1.71 per cent a year. Vanguard’s currency-hedged S&P 500 ETF (VSP) and XSP did a better job between January, 2014, and Dec. 31, 2019. But according to Portfolio Visualizer, they still lagged the index they were supposed to track by 1.17 per cent and 1.20 per cent, respectively, a year.

Mr. Kerzérho’s paper explains how currency hedging is supposed to work – and how it fails. Take an S&P 500 fund hedged to the Canadian dollar: Assume that it has US$100-million in assets under management. At the beginning of the month, it would be long US$100-million in the U.S. S&P 500. At the same time, it would be short US$100-million in foreign contracts versus the Canadian dollar.

If the U.S. index gained 3 per cent that month, it would be long US$103-million. That’s because the 3-per-cent rise in the U.S. market would turn US$100-million into US$103-million. But US$100-million would have been short as a currency hedge. That would leave US$3-million exposed and unhedged. If the U.S. dollar drops, the US$3-million in unhedged dollars would depreciate.

Most financial institutions adjust their hedging once a month. As a result, some of the assets will always be underhedged or overhedged, based on currency fluctuations. If, for example, the S&P 500 lost money over the course of a month, then the fund would become overhedged.

Using the figures above, if the US$100-million long position dropped 3 per cent to US$97-million, the fund would be overhedged by US$3-million – exposing it to potential losses on currency movements. That’s why currency-hedging doesn’t fulfill its promise.

Financial institutions also pay fees to move currencies around. The more transactions they make, the higher the costs. Consider an airport’s currency exchange booth. Give the attendant $10 Canadian and ask for U.S. dollars. After receiving your money, tell the attendant you’ve changed your mind and you want your $10 Canadian back. You’ll get turned down. Big institutions pay smaller currency spreads, but they still pay them. This also reduces returns of currency-hedged ETFs.

Fortunately, simpler solutions make investors more money. If you want to track the S&P 500, you could choose the iShares Core S&P 500 Index ETF (XUS) or Vanguard’s S&P 500 Index ETF (VFV). If you want even broader exposure to U.S. stocks, you could buy the iShares Core S&P U.S. Total Market ETF (XUU) or Vanguard’s U.S. Total Market ETF (VUN).

BMO, iShares and Vanguard also offer several all-in-one portfolio ETFs that include Canadian stock and bond ETFs, as well as U.S. and international stock ETFs – none of which is currency-hedged.

After all, you shouldn’t run a marathon in a pair of hiking boots.

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