Understanding Currency Hedging

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 |  Includes: VOO
by: Dividend Earner

[Originally published on 4/10/2014]

When investing in US ETFs, you sometimes have the choice of picking a Canadian hedged version of the ETF versus buying the US ETF directly in US currency. For many ETFs, the option is available and it’s another decision an investor has to make and often right before pulling the trigger.

What is Currency Hedging?

Currency hedging is protecting your investment from foreign currency fluctuations. Currency hedging is used when the holdings are offered to you in your home currency but the investments are in a foreign currency.

A perfect example is to compare the same index ETF to visualize currency hedging.

VOO – US $ Vanguard S&P 500 index traded on NYSE

VFV – CDN $ Vanguard S&P 500 index traded on TSX

VSP – CDN $ Vanguard CDN hedged S&P 500 index traded on TSX

Here are some questions to ask yourself:

Would you expect all of the 3 investments to perform the same?

Which performs the best?

Why is it the best?

Let’s look at a graph to illustrate their performance and do a comparison. VFV is the CDN version tracking the S&P Index without currency hedging and has benefited from the currency appreciation over the past year. On the other side, VSP (with currency hedging) is staying close to VOO which is the best approximation of the US S&P index in US dollars.

Should You Buy Currency Hedged ETFs?

I am no expert in assessing the performance of currency hedged ETFs but it would appear that both Dan Bortolotti and Andrew Hallam are not in favor of the hedged ETFs. It’s mainly due to the extra cost the hedged version of the ETFs have. The extra cost takes away from the performance of the index ETF and it stops following the index performance which is what you wanted in the first place.

The small percentage difference mentioned by Dan and Andrew is not seen in the Vanguard prospectus as both VFV and VSP have the same MER. It’s in the execution of the currency hedging that you have extra costs and it might not be an issue initially but over 30 years, it can make a difference. Unfortunately, there is only 1 year of data in Google for VSP to get an idea of the long term errors.

As others have said, I think that purchasing the index should be looked at in the following order:

1. Buy the native currency if you can (not always possible with foreign indexes)

2. Buy the non-currency hedged version in your native currency

3. Buy the currency hedged version of the index

At the end of the day, you are buying an index which beats buying actively managed mutual funds but if you are going to invest for a very long time, the small added costs will impact your performance. When looking at a graph, don’t forget that you are looking at past performance.

Disclosure: None