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Foreign funds that aren’t currency hedged won’t win every year. But over the long term, they will.

Ken Drysdale/istockphoto

Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can read more in the series at tgam.ca/strategy-lab.

Time magazine once compiled a list of the 50 worst inventions. My favourite was GLH Hair Treatment For Baldness. "Just spray GLH on and it instantly covers your bald spot." Marketers loved it. But few people wanted to spray-paint their heads. It didn't catch on.

People aren't long fooled when a product doesn't work. Currency-hedged ETFs might prove the point. Canadians have $2.91-million invested in iShares Core S&P 500 Index ETF (XSP). It's currency hedged. Introduced at the end of May, 2001, it's one of Canada's oldest exchange-traded funds. Unfortunately, iShares hedged it to the Canadian dollar.

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Like artificial hair, the idea was a good one. The fund's hedging was supposed to give investors similar listed returns in both U.S. and Canadian dollars. Its aim was to reduce volatility caused by currency movements.

But currency fluctuations aren't always bad. Sometimes, they fall heavily in our favour. This would have been the case with a non-hedged U.S. stock market index in 2015. U.S. stocks gained just 1.24 per cent. But our dollar sank. That means Vanguard's S&P 500 Index ETF (VFV) gained 20.22 per cent last year, when measured in Canadian dollars. In contrast, Vanguard's currency-hedged equivalent (VSP) gained just 0.44 per cent.

Foreign funds that aren't currency hedged won't win every year. But over the long term, they will. Currency hedging drawbacks outweigh the benefits.

Dimensional Fund Advisors researchers Nathan Lacaze and Philipp Meyer-Brauns studied currency hedging with foreign equity funds. Over long periods of time, they found that hedging foreign currencies barely reduces volatility. "Equities are more volatile than currencies, so the volatility of an unhedged global equity portfolio is, on average, dominated by the volatility of the underlying equities, not the currency movements. As a result, unhedged and hedged equity portfolios have similar standard deviations."

Here's how a currency-hedged fund can affect returns. If the U.S. market rises 5 per cent, but the U.S. dollar drops 8 per cent, Canadians will lose money in a non-hedged U.S. index. But if the U.S. market drops 5 per cent but the greenback gains 8 per cent, the same investors would make money.

Unfortunately, attempts to smooth volatility with a currency-hedged index dishes out some hurt. Between June, 2001, and January, 2016, the iShares Core S&P 500 Index ETF (XSP) gained a total of 38.57 per cent.

Canadians couldn't buy an unhedged U.S. stock market ETF before 2001. But TD had its e-Series U.S. stock-market index funds. One was hedged to the Canadian dollar. The second index wasn't. From June, 2001, until January, 2016, TD's unhedged e-Series U.S. index fund gained a total of 77.29 per cent. That's almost 40 per cent better than the iShares Core S&P 500 Index ETF (XSP).

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TD's e-Series U.S. Index Currency Neutral fund is currency hedged. It gained just 46.4 per cent during the same time period.

TD launched both of its e-Series U.S. stock market index funds on Nov. 26, 1999. To Dec. 31, 2015, their currency-hedged version averaged 5.53 per cent a year, over the past 10 years. Their non-hedged version averaged 8.49 per cent.

TD also offers an e-Series U.S. index that trades in U.S. dollars. Over the past 10 years, it gained an average 6.62 per cent. That's what TD's e-Series currency-hedged fund should have made – if hedging actually worked.

Currency-hedging invites hidden costs. Think about a currency exchange booth at an airport. Take a $10 Canadian bill and convert it into U.S. dollars. Then take the U.S. dollars they give you, and ask for $10 Canadian back. They won't let you do it. The spreads you pay between the "buy" and "sell" rates will ensure that you come away with less than $10.

Investors who own currency-hedged ETFs might be tempted to switch. But they shouldn't – at least not yet. The Canadian dollar is low. If you switch now, and the Canadian dollar gains ground, results are going to suffer.

Once the Canadian dollar falls within a normal historical range (somewhere around 80 cents U.S.), then make the switch. And don't look back.

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