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Those who created index funds with hedges against foreign currency swings were certainly well-meaning. But they remind me of the scientists in the short story, Flowers For Algernon. The story is about a mentally disabled man named Charlie who undergoes an operation to increase his intelligence. The operation will, in theory, benefit him. But, in practice, it tragically doesn't.

Currency-hedged index funds, despite their popularity, are similar. Currency fluctuations are natural. If we accept that, we will be better off than if we try to engineer artificial fixes for the problem.

To understand the problems with currency-hedged funds, it's important to recognize that currency fluctuations aren't always bad. If, for example, the Canadian dollar falls against most foreign currencies, then investors could profit from a non-hedged international index, as the growing strength of foreign currencies, against our own, juice the returns of a foreign stock index in Canadian dollars.

Over time, with a diversified portfolio, you sometimes win as the result of currency fluctuations and sometimes lose. If the U.S. market rises 5 per cent, but the U.S. dollar drops 8 per cent, Canadians lose money if they're invested in a U.S. stock market ETF. On the flip-side, if the U.S. market drops 5 per cent but the greenback gains 8 per cent, the same investors would make money.

Buying products that try to smooth these ups and downs through currency hedging involves an extra layer of costs – and that cost can hurt your returns.

In Dan Bortolotti's book, Guide to the Perfect Portfolio, he outlined the true cost of hedging when comparing a U.S.-listed S&P 500 ETF to a currency-hedged S&P 500 fund. In theory, their returns, in local currencies, should be the same, but they're not even close. The currency hedging costs the hedged fund between 1 per cent and 3.5 per cent every year.

According to Raymond Kerzérho, a director of research at PWL Capital, currency-hedged funds are burdened with high internal costs that drag down results.

In a PWL Capital research paper, he examined the returns of hedged S&P 500 indexes between 2006 and 2009. Even though the funds were meant to track the index, they did much worse, underperforming the index they were tracking by an average of 1.49 percentage points per year. Although less dramatic, he also estimated that between 1980 and 2005, when currencies were less volatile, the tracking errors caused by hedging would have cost 0.23 percentage points per year.

The more cross-currency transactions that a fund makes, the higher its expenses – because even financial institutions pay fees to have money moved around. Consider the example of a currency exchange booth at an airport. Take a $10 Canadian bill and convert it into euros. Then take the euros they give you, and ask for $10 Canadian back. You'll get turned down. The spreads you pay between the "buy" and "sell" rates will ensure that you come away with less than $10.

Large institutions don't pay such high spreads, but they still pay spreads.

Then there's the opportunity cost from the hedging itself. Mr. Kerzeho provides an example of a theoretical S&P 500 fund hedged to the Canadian dollar. Assume that it has $100-million (U.S.) in assets under management. At the beginning of the month, it would be long $100-million in the U.S. S&P 500. At the same time, it would be short $100-million – in U.S. dollars – in foreign contracts versus the loonie.

If the U.S. index gained 3 per cent for the month, then it would be long $103-million (because of the rise in the U.S. market). Considering that $100-million was short as a currency hedge, it would leave $3-million exposed and unhedged. If the U.S. dollar drops, the $3-million in unhedged dollars will depreciate.

Because most financial institutions adjust their hedging once per month, fluctuations in currencies ensure that part of the assets are always underhedged or overhedged. 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 $100-million long position dropped 3 per cent to $97-million, the fund would be overhedged by $3-million – exposing it to potential losses on currency movements.

The potential for such a performance lag with foreign market ETFs is the reason I didn't choose currency-hedged ETFs for my Strategy Lab portfolio. At the time the contest began, however, there was no option for Canadian investors to buy a non-hedged foreign market ETF off the Canadian market. I sidestepped this issue by adding international ETFs from the New York Exchange, rather than saddling myself with less inefficient products.

Thanks to Vanguard, however, things are getting a lot better for Canadians. On Nov. 9, the U.S. based index behemoth added a non-hedged S&P 500 ETF to the Toronto stock exchange, costing just 15 basis points. The Bank of Montreal matched Vanguard with its own, equally low cost, non-hedged version.

Noticing the demand, Howard Atkinson, CEO of Horizons ETFs hopes to convert the company's hedged U.S. index to a non-hedged version.

These three ETFs will compete with the currency hedged iShares S&P 500 index. But if history is an indicator, the un-hedged versions will eventually run circles around their deceptively expensive competition.

With luck, an ETF provider will also produce an un-hedged version to compete with the iShares currency-hedged international index as well. Until then, we can either wait, or buy our international exchange traded funds off the New York market.

With indexes, it's best to go with a naturally unhedged product. Accepting the volatility will increase your odds of higher returns.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 17/05/24 3:59pm EDT.

SymbolName% changeLast
Bank of Montreal
Bank of Montreal
Vanguard S&P 500 Index ETF
Xinyuan Real Estate Ltd ADR
BMO S&P 500 Index ETF

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