I want to get some U.S. exposure with an exchange-traded fund that follows the S&P 500 index. With the Canadian dollar going up sharply, should I be looking into a currency-hedged ETF such as XSP or ZUE?
There’s no question that currency-hedged ETFs have performed as advertised during the Canadian dollar’s year-long surge. For the 12 months to April 30, the hedged S&P 500 ETFs from iShares (XSP) and Bank of Montreal (ZUE) posted total returns of 44.2 per cent and 43.8 per cent, respectively – close behind the S&P 500′s return of 46 per cent.
The unhedged versions of these ETFs didn’t perform nearly as well, posting returns of 28.8 per cent (XUS) and 28.4 per cent (ZSP). This isn’t surprising given that the loonie gained about 10 US cents during that period – an exceptionally steep rise that caused the value of U.S. assets to weaken when priced in Canadian dollars.
So does that mean hedged ETFs are the way to go? Not necessarily.
For one thing, there is no guarantee the loonie’s ascent will continue. The forces that drove our dollar to a six-year high – including rising commodity prices, an improving economic outlook and the Bank of Canada’s more hawkish tone on interest rates – may already be baked into its current price of more than 82 US cents, some analysts say.
In a recent Reuters poll of 40 currency strategists, the median forecast was for the Canadian dollar to slip about 1 per cent over the next three months and to trade at about 80.65 US cents one year from now. If that forecast proves to be accurate, there would be no benefit to holding a currency-hedged S&P 500 ETF, whereas an unhedged ETF would get a boost from a weaker loonie.
“This year and particularly of late, CAD [the Canadian dollar] has been the beneficiary of a perfect storm of surging U.S. growth, surging commodities, surging global risk appetite and a hawkish central bank. Our factor analysis suggests that all of this is being reflected in a stronger CAD,” Ben Randol, foreign exchange strategist with BofA Securities, said in a note.
“Our bias remains to buy CAD dips, but we see present levels as overdone.”
Another reason to be wary of currency-hedged ETFs is that they sometimes come with unpleasant tax consequences. At the end of 2020, for example, XSP declared a taxable capital gain of $1.6559 per unit. Its unhedged counterpart, XUS, had a capital gain of just 29.036 cents. Unlike an ETF’s regular distributions, capital gains are typically reinvested in the fund, which means the investor gets a tax liability without receiving any cash.
XSP’s capital gain – equal to about 4 per cent of the ETF’s unit price at the time – was primarily the result of currency hedging. ETFs typically hedge their currency exposure by locking in a “forward” price at which they can sell the U.S. dollar. If the U.S. dollar falls against the Canadian dollar, the forward contract realizes a gain, which offsets the foreign exchange loss of the ETF. If the U.S. dollar rises, the forward agreement realizes a loss, which offsets the ETF’s currency-related gain. The end result is that the ETF should achieve a return, in Canadian dollars, similar to the U.S. index it tracks (minus expenses).
However, because hedged ETFs generally roll their forward contracts on a monthly basis, they realize capital gains and losses throughout the year. If the ETF has a net capital gain at the end of the year – as was the case with XSP – it declares a “reinvested distribution” that transfers the tax liability to unitholders.
The tax implications of currency hedging don’t matter if you hold the ETF in a registered account. But I have heard from a couple of readers who own XSP in a non-registered account and were shocked to see the hefty capital gain when they opened their T3 slips. One reader was hit with tens of thousands of dollars of tax he wasn’t expecting.
Tax drawbacks notwithstanding, currency hedging can still be advantageous during periods when the loonie is rising sharply. Over long time frames, however, the benefits are less clear. Despite outperforming their unhedged peers over the past year, currency-hedged ETFs slightly trailed their plain-vanilla counterparts over the past five years.
Here’s another reason to consider unhedged ETFs: diversification. During periods of financial turmoil, investors often flock to the U.S. dollar for its perceived safety. This pushes up the greenback’s value relative to the Canadian dollar and other currencies. All else being equal, a stronger U.S. dollar will increase the value of an ETF that holds U.S. assets but is priced in Canadian dollars. If you own a hedged ETF, this diversification benefit will be lost.
Currencies are notoriously difficult to predict. If you can’t stand the uncertainty, a hedged ETF may be for you. But if you can live with some volatility, and you’re investing for the long term, an unhedged ETF may be the better choice.
E-mail your questions to firstname.lastname@example.org. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.
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