Currency Exposure

By: Pete
Date posted: 12.06.2011 (11:28 am) | Write a Comment  (0 Comments)

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For most investors, foreign currency exposure is nothing more than an after thought. But in a world where most investors are increasingly diversifying their investments across borders, Why? Because adding countries can get you a higher return for the same amount of risk. There are many different ways but in general it is done by investors buying ETF’s that foreign indexes. One core example would be investors that purchase VWO, a Vanguard ETF that tracks the MSCI Emerging markets index. In such cases,

In some (but not all) cases, investors will have the choice between buying an ETF that is hedged for FX or not. Let’s take the example of a Canadian investor that would like to get exposure to US markets via the S&P500.

There are two main options:

#1-Buying a FX hedged ETF such as XSP (from Ishares)
#2-Buying an ETF with no exposure: Either buying such an ETF in Canada or buying one like IVV on US markets.

The difference between the two returns would mostly be fx returns. For example, if you hold the S&P500 and it gains 10% this year while the USD also gains 10% (in regards to the $CAD) you would get the following:

Option #1 +10%
Option #2 +20%

Of course, in the case where the $USD would have done the opposite, the difference in returns would be the opposite. So there is obviously not one option that will always do better. It’s more about looking for the best option for your portfolio.

What Is The Best Option?

Personally, I clearly prefer owning the non-hedged version in almost all cases. Why?

#1-Hedging Costs and Efficiency: Hedging an ETF sounds simple but it’s much more complex in reality because every movement of the index would in theory require a change in the hedge. That makes the strategy often very expensive (trading costs) but also rarely efficient. There have been many studies where they looked at how well hedged ETF’s have tracked their hedged index and the results have been very disappointing.

#2-Additional Diversification: I think it’s critical to remember why you are buying these ETF’s. It is all about adding diversification and in that regard, having exposure to foreign currencies certainly accomplishes that. You are looking for assets that have different profiles from what you already have and hedged ETF’s are not the best match.

I could certainly agree that getting foreign exposure is not always perfect and in some cases, it will end up costing you. But I would argue that over the long term, you will still be better off holding unhedged exposures.


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