S&P 500 ETFs: To hedge or not to hedge, that is the question

Few Canadian investors question the benefits of diversifying their foreign stock portfolios. The ETF market now offers investors the opportunity to invest in baskets of U.S. and international equity securities at practically paltry management fees. Another major innovation is the appearance of twin foreign index funds, i.e., two identical funds, except that one includes a hedge against currency fluctuations, and one does not. These sets of index funds appeared prior to the year 2000 on the mutual fund market and around 2012 on the ETF market. Just among them, the three biggest Canadian providers (RBC iShares, BMO and Vanguard) offer 34 pairs of twin ETFs. Thus, there is no shortage of choice.

This article focusses specifically on the performance of twin ETFs replicating the performance of the S&P500. This choice includes several advantages. First off, there are many (we’ve selected five), which will help to validate observations. These funds are exposed to a single currency (the U.S. dollar), which makes it possible to better identify the various factors that impact the hedging efficiency. Third, these funds all hold the same portfolio of shares, which makes comparisons more informative. Lastly, we’ve already conducted a study (published in 2010) regarding the performance of S&P 500 hedged funds, which concluded that such hedging included very high implicit costs roughly 1.50% on average per year for the 2006-2009 period. We could, therefore, confirm or dispel this finding based on the new data.

Reasons to hedge

The U.S. stock market and greenback both performed brilliantly on international markets since the latter reached parity with the Canadian dollar at the end of 2010. You might as well say an eternity, even for long-term investors. However, there’s no guarantee that this performance will continue. During the 2000-2010 period, the reverse was true, whereby the greenback declined sharply against the loonie.

Graph 1: Performance of Canadian and U.S. stock markets for the 2000 2010 and 2011-June 2020 periods. Source: PWL Capital

The following three reasons should encourage you to consider currency hedging in whole or in part.

1. U.S. stocks make up a major portion of the portfolio

If your allocation to U.S. stocks is minimal, the U.S. dollar won’t have a major impact on your portfolio. However, if your strategic share allocation requires a significant weighting in U.S. stocks, the greenback will have a major impact on its performance. Everybody loves currencies when they make gains but hate them when they decline. Tell it to Canadian investors who held an S&P 500 fund in 2003, when the nearly 29% return in U.S. dollars was slashed to less than 6% owing to the sharp decline of the greenback against the Canadian dollar.

2. You invest to provide for expenses that will be incurred in Canadian dollars

If you’re like me and you love winter, you may be planning to retire in Canada. If the objective of your portfolio is to provide for expenses incurred in Canadian dollars, then you’ll be less tolerant to currency risk.

3. You have a limited tolerance for losing money due to currency

Sometimes, the U.S. dollar can decline in value over a period of many years. These periods are illustrated by the shaded areas in the graph below.

Graph 2: Value of one U.S. dollar in Canadian dollars 1971-2020. Source: PWL Capital

If you believe that exposure to the U.S. dollar carries only a small risk, read the following carefully: between 2001 and 2007, the greenback shed 41% of its value against the loonie. And during this time, the U.S. stock market significantly underperformed the Canadian stock market. At that point, the risk that investors had to watch out for was that of losing patience with their U.S. stocks due to this setback. We know what happened next: U.S. stocks and the greenback both subsequently enjoyed a golden era. In short, if a hedge—even a partial one—on the exchange risk can help you hold on to your U.S. stocks, you should seriously consider it.

Reasons not to hedge

If there are compelling arguments for hedging, there are also good reasons not to hedge. Here are a few of them.

1. The U.S. dollar often has a parachute effect during major crises

During major crises, the U.S. dollar sometimes serves as a safe haven, which means that the losses on your U.S. stocks are partly offset by the appreciation in the currency. For example, during 2008, the S&P 500 Index delivered a -37% performance in local currency terms; however, the decline was clearly less severe, i.e. -23%, once converted into Canadian dollars. The same phenomenon occurred during the crisis that took place last February and March. As an investor, you cannot avoid market slumps; however, you can structure your portfolio so that it mitigates the impact. To that end, there is a good chance that exposure to the U.S. dollar could prove helpful to you.

2. You will need U.S. dollars in the future

If you’re planning to buy a condo or cottage in the United States or to make frequent visits there when you retire, the U.S. dollar becomes less risky with respect to your personal situation.

3. Currency risk hedging is expensive

Currency-hedged funds are a real help to those investors seeking protection against currency risk. Without these products, you yourself would be required to manage a portfolio of currency forward contracts in order to achieve the hedge. By opting for an ETF or mutual fund that is hedged against fluctuations in the U.S. dollar, you delegate this task to the fund manager. However, my research has shown that currency hedging cannot do a perfect job. As soon as the value of the stock in the portfolio fluctuates, the amount of the currency forward contracts either becomes too high, or too low. This hedging imperfection, known as “the residual-currency effect’’ or “RCE’’, will tend to cancel itself out over time if the U.S. dollar and S&P 500 Index fluctuate independently. But in reality, their correlation has consistently proven negative since the adoption of the floating exchange rate system in 1971.

Graph 3: Correlation between the U.S. dollar and the S&P 500 Index, 1971-2020. Source: PWL Capital NB: Correlation over 60 months

I have analyzed the efficiency of hedging transactions using the data on hedged and unhedged funds. In fact, since currency hedging is all that distinguishes one such fund from another, we can accurately calculate the effect of the transaction costs and the residual-currency effect on the performance by adjusting their performance differential based on the returns of one-month forward contracts on the Canadian dollar (forward exchange rates vs. the U.S. dollar).

According to the analysis of comparative performances of hedged and unhedged funds, since 2000, the annual cost of the residual-currency effect, and transaction costs to S&P 500 hedged fund investors was 0.99%. This difference has since diminished, perhaps because of greater care that was taken with respect to managing the hedge; but even since 2013 (when we have a larger sample of twin funds), the RCE has cost investors 0.67% on average. This result is stable enough among the five funds being analyzed, with a range varying from 0.60% to 0.74%.

To hedge or not to hedge?

Ultimately, investors need to understand that hedging the currency risk of a U.S. equity fund involves a significant cost, largely because of the consistent negative correlation between the returns of the greenback on the one hand, and the U.S. stock market on the other. Even though this cost is not as high as our previous studies had estimated, a cost evaluated minimally at 0.67% is considerable with regards to the expected returns of asset classes. We suggest using currency-hedged U.S. equity ETFs only if the three required conditions (high weighting in U.S. stocks, fund use profile that includes few U.S. dollars, limited tolerance to currency risk) are met.

Table 1: Hedged and unhedged mutual funds and ETFs on the S&P 500

Source: PWL Capital

Technical Note: the residual-currency effect explained

When we add currency hedging to an S&P 500 Index portfolio, simple logic dictates that we should expect to receive in Canadian dollars the same return obtained by investors in U.S. dollars, since the objective of the hedging transaction is specifically to offset the effect of exchange rate fluctuations. However, in reality, things are more complicated.

First, forward contracts used to hedge currency risk are traded based on the current exchange (or “spot’’) rate, but they also integrate a component to take account of the difference in the interest rates in Canadian and U.S. dollars. In short, when the Canadian rates are higher than the U.S. rates, the hedging transactions will add some return to the funds, and vice-versa when the U.S. rates are higher.

The other factor that creates a difference between the returns of hedged versus unhedged funds calculated in U.S. dollars is the residual-currency effect. Generally, when the U.S. stock portfolio and U.S. dollar fluctuate in the same direction, the hedged funds will surpass the unhedged funds calculated in U.S. dollars. The reverse is true where the U.S. stock portfolio and U.S. dollar fluctuate in opposite directions. The following case study illustrates how this works.

Case No. 1: The S&P 500 Index and the U.S. dollar are both up 3%

Let’s say that a fund holds shares of U.S. stock worth US$100 million dollars under management at the start of the month. The fund sells forward contracts for US$100 million dollars (vs. the Canadian dollar) in order to hedge the currency risk.

At the start of the month, the position is described as follows:

• Long position – US$100 million dollars on S&P 500 funds
• Short position – forward contracts on US$100 million dollars (vs. the Canadian dollar)

If, during the month, the S&P 500 Index generates a +3% return, then the portfolio held by the fund becomes:

• Long position – US$103 million dollars on S&P 500 funds
• Short position – forward contracts on US$100 million dollars (vs. the Canadian dollar)

Consequently, the fund is now under-hedged by US$3 million dollars. In other words, the fund is long net of US$3 million (US$103 million in S&P 500 shares less $100 million dollars short on the U.S. dollar).

If, during the month, the value of the U.S. dollar increases, the US$3 million-dollar under-hedging will generate a profit. Consequently, the fund’s return for the month is:

The fund’s return is 0.09% greater than the S&P 500’s return.

Case No. 2: S&P 500 Index +3%, U.S. dollar -3%

 Now, let’s say that the S&P 500 Index generates a +3% return during the month, but contrary to Case No. 1, the U.S. dollar falls 3%. Therefore, the portfolio held by the fund becomes:

• Long position – US$103 million dollars on S&P 500 funds

• Short position – forward contracts on US$100 million dollars (vs. the Canadian dollar)

At this point, the value of the forward contracts remains US$100 million dollars since the hedging transactions are carried out at the start of each month. Consequently, [US$103 million dollars – US$100 million dollars] = US$3 million dollars are not hedged. The fund is now under-hedged and the excess exposure to the U.S. dollar will generate a loss. Consequently, the fund’s return for the month is:

The fund’s return is 0.09% lower than the S&P 500’s return.