Tuesday, 14 June 2011

S&P 500 Currency Hedged ETFs - How Well do They Work and Which is the Best?

The ordinary investor's goal for including an ETF that hedges currency while investing in an S&P 500 index tracker is to gain exposure to diversification and the returns of the US equity market while removing the possible damaging effects of a climbing Canadian dollar. There are such two ETFs available in Canada, both traded in Canadian dollars on the TSX:
The inner workings have some similarities and some marked differences, some good and some bad for the investor and some surprising characteristics that reduce their effectiveness exactly at the wrong time while enhancing returns at other times. Our chart below provides details of these key points.

MER, including the new in 2010 HST - each fund has a management fee, HXS' a bit lower than XSP's, but that is just the beginning as MER is a minor drag on returns compared to other factors

Swap Fee - 0.30% for HXS only, none for XSP. HXS obtains the returns of the S&P 500 through an agreement with the National Bank in which the Bank swaps the return of the S&P 500 index in exchange for the swap fee and interest on cash held by HXS. Canadian Capitalist described this ingenious method of tracking an index, much practiced in Europe, in this post.

Residual Currency Effect - Here is the first zinger. The constant movement of both currencies and the stock market means that it is impossible to hedge perfectly at every moment. Find out how and why in An Imperfect Hedge: The Limitations of Currency Hedging by Philip Falls and Dino Bourdos in the April 2010 Pension & Benefits Monitor and Currency Hedged S&P 500 Funds: The Unsuspected Challenges by Raymond Kerzérho of PWL Capital. The bottom line is that hedging works least well precisely when investors want it most - at periods of extreme stock and currency volatility, such as during the 2008 and 2009 financial crisis. The crisis period gave the worst tracking results vs the benchmark index. There is some debate whether the right benchmark is the native US dollar percentage returns of the S&P 500, which is the simple objective of an ordinary investor, or the percentage returns of the hedged S&P 500 index, which both iShares and Horizons insist is the right way to track. Using either index the results are bad, it just looks far worse when the Canadian investor's hedged percentage returns in CAD are compared to the "native" S&P 500 percentage US dollar results such as a US investor would have obtained - see Canadian Capitalist here for some of the ugly numbers. Ironically, when both the USD and the S&P 500 are dropping simultaneously, the hedged tracks the native results very closely! Big sudden moves in opposite directions are what hurt most. At present the environment looks quite tame and both HXS and XSP in the last six months (see table below) have been only 0.1 - 0.25% below both the S&P 500 hedged index and the native index.

US Withholding Tax - XSP owns US shares through its holding of the US iShares S&P 500 ETF (IVV) and the US government deducts the standard 15% withholding tax on distributions. In a registered account (see our dissection of this issue here) XSP shareholders cannot get this amount back, neither as a tax credit, nor by preventing it being deducted. At the current S&P 500 dividend yield of 1.73% that means there is a 0.26% return reduction on XSP in registered accounts compared to HXS, which receives no distributions per se (they are implicitly included in the swap return) and certainly not from the US, only from the National Bank (whether the Bank suffers the 15% tax has no effect on HXS shareholders since the swap provides HXS the index return, which calculates no deduction for tax). In taxable accounts HXS and XSP are equal. HXS has not paid any tax while XSP shareholders can deduct it as a credit against other taxes.

Canadian Income Tax - Here is another big return-reducing area, with significant potential advantages of HXS over XSP in taxable accounts. In registered accounts, neither has a problem since there is no tax levied against any type of gains or income, as is usual.

In taxable accounts, HXS' swap structure means that all returns, both price advances of the S&P and its dividends, a) become capital gains and b) become realized and taxable only when the investor finally sells the HXS shares. In contrast, XSP receives dividends and makes distributions every year, which are a) taxable each year upon receipt and b) taxed at the same rate as ordinary income, which is double the capital gains rate. There is a significant net return reduction to both funds but it is up to double or more for XSP compared to HXS. Our comparison table shows that the advantage of HXS is more pronounced when the S&P 500 dividend yield is higher, the gains are deferred longer and the taxpayer is in a higher tax bracket.

Interest Rate Spread - The use of forward contracts by both funds to implement the hedging creates a net benefit, or cost, to the fund as a result of differences in short term interest rates between Canada (as represented by something called CDOR) and the USA (LIBOR). At the moment, Canadian rates are about 1% higher than US rates, which means HXS and XSP are making money from the forward contracts themselves. That extra return, especially with the difference being quite high right now, could cause the funds to outperform the index! While it lasts, it will at least drastically reduce the historical under-performance of hedge funds noted above.

Of course, in taxable accounts, the extra income gets taxed. In 2010, XSP shareholders had to pay taxes on substantial capital gains generated by forward hedging contracts. HXS will not have this negative since the National Bank does the hedging and although the hedging profit accrues to the fund through returns of the hedged index, the gain is not distributed annually to HXS shareholders and there is not tax to pay immediately. The HXS website and Prospectus has announced the intention not to make any distributions at all.

Investor's Trading Costs - There are several other factors that an investor faces when buying and selling ETF shares which can either boost or reduce returns:
  • Bid-Ask Price Spread - Pull up a quote from a website such as TMX.com and it will show the lowest price at which someone is willing to sell - the Ask price - and the highest price someone at that moment is offering to buy - the Bid price. The lowest possible spread between the two is the best - one cent. A big spread represents a cost to the investor. XSP comes out much better than HXS with a much smaller spread on average. The end of trading bid-ask quote on June 10th is significant not so much for the positive or negative sign, since that can and does switch back and forth between positive and negative regularly for each fund. It is more the size of the spread that matters. XSP should almost always have a much smaller spread and that is a benefit to the investor. Its asset size and trading volume ensure a more efficient market than for HXS. It is hard to quantify the impact of the higher spread since it will depend on how much trading an investor does (more trades = more cost) and holding period (longer = less cost because the cost is averaged over more years).
  • Price vs Net Asset Value (NAV) Premium or Discount - The ETF size and trading volume also drives this return/cost factor. The market price of XSP or HXS may deviate from the actual fair value of the stocks within the S&P 500 index. It may be higher, which is called trading at a Premium. In this case, the investor who buys at the market price pays more than the stock is worth. Or it may be lower, at a Discount, which means paying less than it is worth. Horizons publishes HXS' updated (every 15 seconds) Intra-day NAV here such that one can compare it with market price in a real-time quote from a broker website (as opposed to the 15-20 minute delayed quotes in TMX, Yahoo Finance, GlobeInvestor and other free public sites), but unfortunately iShares does not publish this data for its ETFs. There are constant fluctuations of price above and below NAV as arbitrage by market players keeps the Premium or Discount down but it will be a lot closer on average for higher volume XSP than for HXS. The lower the deviation, the better for investors so XSP is much better on this factor.
  • Dividend Reinvestment Commission - Since HXS incorporates implicit automatic dividend reinvestment as a result of the swap for the total return of the S&P 500 (capital gains plus dividends), it has zero cost for this operation. The XSP investor must remember to reinvest the cash dividends received twice a year, as well as pay the broker commission. HXS is thus superior to XSP on this cost factor.
Risk Factors of HXS - The structure of HXS based on swap derivatives presents several special risks unique to HXS that XSP does not have.
  • Counterparty risk - Up to 10% of the value of the positive returns of the S&P 500 could be lost to XSP shareholders in the event of default of the National Bank. It is the returns only, not the principal value of HXS, that is possibly at risk, and only up to 10% of returns, since the Bank must provide collateral beyond that amount, and it is only positive returns, since in the event of losses, it is HXS that must pay the Bank money (the swap tracks the gains and the losses of the S&P 500). How serious a risk this factor represents is a matter of judgment, since the National Bank would have to fail at a time when the market is going up. During the financial crisis, when many banks did fail, the market was going down a lot, not up.
  • Swap expiry risk - If Horizons decided to terminate HXS and thus the swap, the embedded capital gains would be realized involuntarily by shareholders. Assuming the market goes up over the long term, that would create a sudden potential tax hit for HXS holdings in taxable accounts. The current swap with National Bank is due to expire in 2015 but Horizons says it intends to renew and roll it over indefinitely so that the tax hit does come about, but the possibility exists. In this blogger's opinion, the small current asset size of HXS makes this risk a concern at the moment.
Bottom Line
  • XSP and HXS both will be much more efficient hedging tools and will track the S&P 500 percentage returns much more closely (within 0.3% per year) as long as lower market and currency volatility and higher Canadian vs US interest rates continue.
  • HXS has appreciable cost advantages over XSP for holdings in registered accounts and especially for holdings in taxable accounts of high marginal rate investors. However,
  • HXS has some extra risk over XSP which counterbalances to some degree the return advantage.
Additional Reading:
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


Anonymous said...

Hey - I am definitely delighted to discover this. great job!

Anonymous said...

Very well researched!

Mar k Walusimbi said...

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