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Most investors understand that currency-hedged foreign funds will have a higher management expense ratio (MER) due to the hedging costs. What may escape them, however, is the fact that such currency-hedged funds can also have rather large “tracking errors.” This makes the cost of currency hedging quite high for the long-term investor, says blogger Canadian Capitalist in a recent post.

Take the example of a Canadian wishing to buy into the S&P 500 Index: they can get the currency-hedged iShares CDN S&P 500 Index Fund or the unhedged iShares S&P 500 Index Fund (NYSEARCA:IVV). The MER for XSP is 0.15% higher, which doesn’t look too bad. But then, as Canadian Capitalist calculated, the XSP trailed IVV by -1.73%, -2.30% and -3.5% in 2006, 2007, and 2008, respectively.

The iShares.ca website reports a smaller “tracking error” of 0.34%, 0.56% and 1.31% for those years. But their benchmark was a currency-hedged version of the S&P 500. The difference in Canadian Capitalist’s and iShares.ca estimates mostly represents the tracking error of the latter’s currency-hedged benchmark against the actual S&P 500 Index. As iShares Canada Head of Business Development, Heather Pelant, coveyed in an email:

An important thing to consider however, is that the benchmark of XSP is not the basic S&P 500, but a currency hedged version of this index which is calculated by S&P. That hedged index has in fact has somewhat underperformed the basic S&P 500 over the last couple of years

The difference between the basic and hedged indices results from a few factors - one is the cost of implementing the currency hedge…. Another is interest rate differentials, which impact on the pricing and performance of forward contracts used in hedging. Finally, market volatility affects the way currency hedged investments compare to un-hedged alternatives.

The fund’s tracking against the hedged index is affected by transaction costs for trading the currency hedges, management/trustee fees, and in 2008, market volatility. The unprecedented volatility of markets in 2008 significantly affected the management of currency-hedged strategies.

The IVV itself tracking the basic S&P 500 index almost perfectly, with all tracking error essentially the result of management fees.”

So that explains the difference in tracking error estimates. For the index investor, the tracking error relevant to their experience will be the one estimated by Canadian Capitalist. If currency fluctuations average out over the long run, as he says, currency hedging is not likely the way for most long-term investors to go when diversifying into foreign markets. The cost can be high. Check the tracking error.

Source: Check the Tracking Error Margin For Currency ETFs