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Rob Carrick

Water-wings no longer needed when investing in U.S. waters Add to ...

Time to put those water-wings away, ETF investors.

With our dollar trading near par with its U.S. counterpart, it no longer makes sense to get your exposure to American stocks through TSX-listed exchange-traded funds that use currency hedging. Sure, hedging kept you afloat in the years when a soaring loonie swamped the gains produced by U.S. stocks. Today, though, hedging is a costly drag on returns. You're better off investing without it.

Practically speaking, this means you won't be needing the growing number of ETFs on the Toronto Stock Exchange that provide hedged exposure to key U.S. stock indexes like the Dow Jones Industrial Average, the S&P 500 and the Russell 2000. Instead, you'll buy exposure to these and other U.S. indexes using ETFs listed on the New York Stock Exchange.

The underlying assumption here is that our dollar's correct position in the global financial world isn't at par with the U.S. dollar. In fact, the 10-year average value for the loonie is 79.7 cents (U.S.). This includes the depths of early 2002, when the currency plunged all the way down to just over 62 cents, and the heights reached in November 2007, when the currency reached $1.10. At parity, you have to figure our dollar is much closer to the high end of its recent valuation range than the low end. Put another way, history tells us there's much less room for the dollar to rise than for it to coast sideways or fall in value.

Hedging is only of value when the dollar is rising, and even then it's of debatable benefit because of its clumsy lack of precision and its cost. Currency hedging is carried out using financial instruments called options, futures or forward contracts. The point with U.S.-market ETFs is to deliver the return of the underlying index without distortions caused by currency fluctuations. Imagine you hold an ETF tracking the S&P 500 stock index. If the S&P 500 rises 5 per cent in a year and the Canadian dollar appreciates 5 per cent against the U.S. dollar, then an unhedged ETF would have a gross return of zero. The net return would be a little less than zero to reflect management fees. With a hedged ETF, you would ideally make just a little bit less than 5 per cent.

That's the ideal world of hedging. In reality, it often disappoints. Check out these numbers for the iShares S&P 500 Index Fund , which uses hedging. For the three years to Oct. 31, its average annual loss of 9.5 per cent compares to a loss of 4.3 per cent for the S&P 500 index in Canadian dollars. What went wrong? Hedging, for one thing. Stock markets are highly volatile these days, but ETF currency hedges typically get reset monthly. If the stock market surges ahead early in the month, a significant chunk of its assets may not be protected by hedging and thus vulnerable to currency moves.

Hedging also adds to the cost of owning an ETF, though not dramatically. For a U.S.-market fund, the extra cost might add somewhere between 0.5 and 0.1 of a percentage point.

Forgoing hedging means there will be downward pressure on the value of your U.S.-market ETFs if our dollar rises. But when the loonie declines, and history tells us it most certainly will fall at some point, you'll see just the reverse happen. Whatever U.S. indexes do, you'll make a little extra thanks to currency moves.

Buying U.S.-market ETFs on the NYSE means you'll have to pay your broker's stiff foreign exchange rates for converting Canadian dollars into U.S. currency. But that will be offset by the lower management fees charged by U.S. ETFs. XSP, the hedged TSX-listed ETF for the S&P 500, has a management fee of 0.24 per cent. You can get that fee down to 0.06 per cent using the Vanguard S&P 500 ETF .

When the Canadian dollar was charging higher, water-wings were a must-have accessory for investors swimming in U.S. waters. Today, they're superfluous. Time to hang 'em up.

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Follow on Twitter: @rcarrick


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