Friday, 27 September 2013

Hedging Foreign Currency Exposure - Is it worth it? CalPERS Changes Tack and ETF Case Studies

A few weeks ago, the California Public Employees' Retirement System (CalPERS) reviewed its Currency Overlay Program review and decided to stop hedging its foreign currency exposure. Hedging aims to eliminate the effect of foreign currency swings on the returns of foreign holdings, especially to mitigate the steady appreciation of one's own currency which reduces foreign returns. That the sixth largest pension fund in the world, which is about 50% bigger than Canada's national CPPIB fund, has made that decision should cause us to reflect.

Currency hedging has not helped CalPERS
CalPERS' aim when it set up the program in 1992 was to reduce the volatility of the total fund portfolio arising from the rise and fall of foreign currencies against the US dollar associated with its substantial foreign holdings. But CalPERS has found that ... "There are no statistically significant benefits, such as • Decreases in volatility, and • Increases in net returns". In addition, they have found that the hedging is costly and complicated to carry out.

Pension fund peers for the most part do not hedge either
Part of CalPERS decision process was to review what other pension funds are doing about their foreign investment currency exposure. More than half, according to Appendix 2 (image below) of the Currency Overlay Program document, don't have a policy to hedge and of those that do, only apply it to specific types of assets like fixed income or a minor portion of equity. CalPERS itself only hedged 15% of its foreign positions up to the change.
(click on image to enlarge)

Canadian Dollar-Hedged ETFs are popular in Canada
There are quite a few Canadian-based ETFs that hedge their foreign currency exposure. A search on ETF Insight for US equity ETFs traded in Canada pulls up 41 ETFs, of which more than half - 21 - hedge against US dollar shifts. The ETF with the largest assets by far - iShares S&P 500 Index Fund (CAD-Hedged) (TSX symbol: XSP) - is hedged. Similarly, the largest foreign equity developed country ETF - iShares MSCI EAFE Index Fund (CAD-Hedged) (XIN) - is hedged. (Important note: the hedge in XIN is against the currencies of the under-lying foreign countries like Euro/Yen/Sterling versus the Canadian dollar, NOT the US dollar, even though XIN holds the US dollar-traded iShares MSCI EAFE (EFA) - Canadian Couch Potato explains the idea and CanadianFinancialDIY gives a numerical example.)

Why are hedged ETFs so popular?
Likely it's the reaction of investors to the trend in the Canadian dollar (CAD) versus the US dollar (USD), shown in the Trading Economics chart below. The chart line displays the number of Canadian dollars per USD. The rising line up to about 2002 meant that it took more and more CAD to buy one USD, the peak being around $1.60 CAD per USD i.e. CAD depreciation. Depreciating CAD means an investor's USD investments are worth more when translated back into CAD. That boosts returns in terms of CAD. Thus, we have labelled that part of the line with green text since it is beneficial for a Canadian investor. Conversely, since 2002 CAD has been appreciating vs USD (fewer CAD required to buy one USD). The line has been generally trending down and that has had a negative effect on a Canadian's USD investments - thus our red text. The trend was temporarily interrupted during the 2008 financial crisis as the flight to the safety of the USD caused a large spike of USD appreciation/CAD depreciation. That turned out to be hugely beneficial for Canadian investors with USD holdings since it offset a significant portion of the equity market drop, as we wrote at the time and show below in discussing an investment in the S&P 500.

S&P 500 Case Study

How would a Canadian investor in the main US equity benchmark the S&P 500 have fared? Would it have been better to hedge against currency effects or not? We'll use the Stingy Investor Asset Mixer tool, which gives us historical results and conveniently has a selector to display returns either in CAD (i.e. unhedged) or in USD (hedged). The tool allows selection of start and stop years for annual returns back to 1970. We'll compare results against the most popular CAD-hedged S&P 500 ETF mentioned above, iShares' XSP, which has now been in existence for ten years.

The results are in the comparison table below. As usual green numbers are good, red are bad and the red outline cells are especially shocking.

Returns in the last ten years (2003-2012) have been better for a CAD-hedged S&P 500, which jives with the return-sapping effect of a Canadian dollar that appreciated during that period. That first line of our table, highlighted in yellow, shows the benefit of hedging. But note the red outline cells - the actual compound return of XSP the ETF falls way short of its CAD-hedged index. Why? The idea of hedging is simple but it is very challenging in practice to carry out effectively. It's one of the reasons CalPERS cited for abandoning its hedging program.

A second result of note is that the non-hedged S&P 500 experienced much less volatility and a much smaller drop in 2008 when translated into CAD.

The third point we note is that in the long term (we've used the maximum data available from Stingy Investor of 43 years from 1970-2012), things even out a lot. There hasn't been a huge difference in returns between hedging and not hedging ... except that the results are before the practical difficulties and the return reduction from implementing hedging are factored in. The Stingy tool uses index returns so it is useful for comparing two indices but not for what actual ETF results will be.

MSCI EAFE Case Study
The same pattern of results comes from comparing the developed country MSCI EAFE (Europe, Australasia, Far East) index and its Canadian hedged version from iShares (TSX: XIN). 1) The hedged index return exceeds the non-hedged index in the short term of the last ten years but in the long term it evens out considerably; 2) the worst drop was much less for the non-hedged vs the hedged EAFE; 3) the actual ETF XIN's return is substantially below that of its index and on the basis of return to risk / volatility the unhedged version does better. A non-hedged EAFE ETF will not incur the large and chronic return reductions from the practicalities of the hedging activity, as we note when comparing the index vs ETF actual results for the under-lying fund of XIN, the iShares MSCI EAFE (NYSE: EFA). EFA's 10-year compound total return up to the end of 2012 was 5.27% and its index was 5.32%, a much smaller shortfall than XIN's.

Bottom Line: It does not appear to be worthwhile for the long term Canadian investor to hold currency hedged ETFs. The non-hedged versions, whether traded in Canada or the USA, make more sense.

Further reading -
Globe and Mail article by Andrew Hallam on the practical problems and costs with hedging and why the return drag won't go away

Previous posts on currency hedging:
Foreign Investments: To Hedge or Not to Hedge Currency
The Historical Effect of Inflation and Currency on a Canadian Investor's International Portfolio
Foreign Investments: What does history tell us about hedging currency?

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.

Monday, 23 September 2013

Emerging Markets ETFs Comparison Update - Which is best?

It has been almost three years since we first compared the main broadly-diversified ETFs for US-traded and Canadian-traded Emerging Markets equities. Things have changed with some new entrants and evolution of existing options. Emerging markets like China, Russia Taiwan, Brazil and South Korea are ever more important economic players. It's time for an update.

At the same time we'll integrate information on the pros and cons of buying ETFs on US markets, especially the effect of foreign withholding taxes, that we wrote about here. We'll focus on broadly based ETFs that aim to diversify across all emerging markets countries and all industry sectors and pick the biggest ones amongst the many listed in the USA - see the scores of offerings in the ETF Database list of emerging market ETFs here.

Two sets of ETF choices ...
The largest divide in the options is between traditional passive, cap-weighted index portfolios and those based on a variety of alternative strategies that have been gaining popularity - such as fundamental accounting data weighting, high dividend payout and low portfolio volatility.

1) Traditional Cap-Weighted Index ETFs
Some are traded in US dollars on US stock exchanges, others in Canada in Canadian dollars, though they all ultimately hold equities of emerging markets countries. As our comparison table below shows, the asset base of US ETFs dwarf those of Canadian ETFs.

 2) Alternative Strategy ETFs
There is also a mix of Canadian and US-traded ETFs in this group.

Costs - MER and Bid-Ask Trading Spread
Management Expense Ratios (MER) are very important because they come right off the bottom line of returns to the investor. Since they get charged every year over the long term they can seriously undermine returns. In other words, the lower MER the better. SCHE at 0.15% is the lowest/best of all, followed closely by VWO and IEMG at 0.18%, with EEMV the best amongst the alternative strategies at 0.25%. Unfortunately, the best Canadian ETF VEE is a fair bit higher at an MER of 0.37%.

The gigantic size of the US ETFs ensures plenty of trading volume, which in turn means the spread between bid and ask prices is always very tight. That is a cost to the investor but is a relatively minor factor for long term buy and hold investors.

Cash Yield - a large range and effects of MER
It isn't surprising to see DEM with highest percentage of cash distributed to shareholders over the past twelve months since that is the ETF's strategy. However, it is surprising how little ahead - 3.9% vs 3.7% - it is over VWO, which pays no attention to this factor. It is also surprising to see the big spread of results across the ETFs, even those that use the same cap-weight approach.

All the Canadian clone ETFs have a significantly lower yield than thier respective US holding, illustrating that the higher MER needs to be paid from somewhere. PXH, which weights in part according to dividends, also loses ground from its higher MER.

Sharpe Ratio and Volatility - foreign currency effects have helped recently
Sharpe Ratio (see Investopedia explanation) is a measure of return per unit of risk/ volatility. The higher it is, the better - more bang for the buck risked in effect. XMM with its much lower volatility and higher return wins handily on this measure.

The reason XMM achieved a higher return than its US holding EEMV, is that a falling Canadian dollar over the past year has boosted the value of EEMV within it. Since our table shows returns in the local currency of trading, EEMV's returns are lower in terms of US dollars. But a Canadian holding EEMV would see a higher return once the value of EEMV was translated into Canadian dollars. We discussed the beneficial effect of foreign currency in this long ago post and illustrated how it would have affected a diversified portfolio in this post. Of course, the effect can go the other way and hurt returns if our dollar strengthens against the currencies of emerging countries. The yellow-outlined cells in our table show for one clone ETF pair where foreign currency effects are influencing the differential USA vs Canada ETF figures.

Attractive prices? Weak returns but valuation ratios vary
The trailing one- and three-returns for all of our ETFs look quite low, which would normally make one think a turn-around is in the offing. But valuation ratios of price to earnings at 17+ and price to book value are not that low for most of the ETFs. PXH, DEM, VWO and SCHE are the exceptions with attractive ratios. Some people believe some markets like India are good buy at the moment. Long term investors with a defined asset allocation will know when their portfolio rebalancing threshold is breached.

Foreign withholding taxes - beware which account to hold which ETF
We have copied the results of the discussion in this post about the subtle and complicated effects of foreign withholding taxes on a Canadian investor, depending on which account the various types of ETF are held. Ironically, many ETFs traded in Canada are worse for a Canadian investor! In particular, the clone ETFs which only hold a US ETF get dinged by US 15% withholding taxes that cannot be recovered or avoided when the ETF is in any type of registered account. TFSAs and RESPs are not good places from a withholding tax perspective to hold any emerging market ETF.

Portfolio holdings differ markedly - mind South Korea, Russia, India and sector weights
FTSE does not consider South Korea to be an emerging market country while MSCI does. Depending on the combination of developed market ETFs in a portfolio, an investor might end up having South Korea doubled up or worse, absent, which would defeat the aim of worldwide diversification considering the country is such a large economy. We wrote a guide to figuring out ETF combinations for country coverage when Vanguard decided to change from MSCI to FTSE as its index. In the comparison tables below blue highlighted text indicates where an ETF departs a lot from the weights amongst the group.

Similarly, Russia and India are also major economies, but due to their respective index rules, most of the ETFs have little or none of one or both countries represented. VWO, PXH and CWO are the exceptions with both India and Russia occupying major places, which we believe make them better for doing so. However, PXH and CWO are very concentrated in the six biggest countries. All the market cap ETFs are much less concentrated in terms of top ten company or top six country exposure. Overall VWO wins on balance for portfolio characteristics.

Other cost factors for the US vs Canadian ETF decision
There are other important cost factors that are not incorporated in the table e.g. the cost for a Canadian investor convert Canadian into US dollars or vice versa, which may cost up to 1.5% depending on the broker; the size and frequency of contributions or rebalancing, the level of yield interacting with withholding taxes, ETF tracking error. Canadian Couch Potato developed a spreadsheet to enable investors to crunch numbers with various scenarios but concluded that long term buy and hold investors are better off with US ETFs. We built a similar spreadsheet tool to calculate the cost of US vs Canadian ETFs and we found that the best choice might vary with assumptions.

Bottom LineVWO is the default overall emerging market ETF of choice at the moment due to its combination of low MER, low trading (bid-ask spread) costs, tax characteristics for Canadian accounts, good yield, attractive P/E and P/B valuation and portfolio diversification.

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.

Friday, 13 September 2013

Fixed Income - the best rates in Canada across the maturity spectrum

Looking for safety and steady income over a set number of years for your portfolio and want the best rate possible? There is a variety of choices available to the online investor. Though there are additional important aspects to consider (which we have previously explored separately - read the links tagged to the options below for details), today we'll look only for the highest rate available for specific future years to maturity from 1 year to over 20 years considering only investment grade securities i.e. with considerable safety / high credit rating (check ratings for any government/company issuer like the Province of Ontario at DBRS).

Here are the options we've examined:
  • High interest savings account - BMO's version (symbol: AAT770)
  • Guaranteed Investment Certificates (GIC) - our biggest constraint here is to select only from GICs available from our discount broker BMO Investorline, ignoring a few that might have higher rates but which require going direct to the provider
  • Corporate, federal and provincial government bonds as individual bonds and in target maturity ETFs, or traditional ever-renewing ETFs (we've included these evergreen ETFs despite lack of a hard maturity date as they have a defined and fairly constant term and duration - see this previous post comparing the ins and outs of fixed income alternatives)
  • Preferred shares of individual companies (previous post here) - we have limited our choice to the few securities with a firm redemption date at which the investor gets back a specific principal amount and ignored the many other types of preferreds whose end date depends on the choice of the issuer
  • Preferred shares of split share corporations (see posts here and here), with under-lying holdings of either a single company or multiple companies
Comparison Table
The table below shows the best options across each type of security. Different individual GICs and corporate bonds were used to match up the maturities as closely as possible for each credit risk rating. Note that exact numbers shift constantly, making it necessary to double check the rate before buying, though the relationship and magnitude of the differences should be pretty close for a short while after this is posted. Green text shows the best rates.

The first thing we note is that a number of alternatives, shown in red text, at the short end of maturities, such as a high interest savings account, federal government Canada T-Bills or bonds and Province of Ontario bonds, don't even provide a return over the latest 1.3% annual inflation rate. The second thing we see is that there are some dramatic differences between alternatives with the very same credit risk e.g. the top paying 2 year GIC yields 2.11% while a Canada bond pays only 0.69%.

Comparison Chart
The table is quite busy so we have extracted the best rate for each maturity and created the chart below.

Up to 3 years maturity, ultra safe GICs, such as Equitable Bank or Manulife Bank, beat out just about everything. The exception is two split share corporation preferred shares, both from the same issuer - Partners Value Split Corp. Preferred Shares 4.95% Class AA Series I (BNA.PR.B) and Partners Value Split Corp. Preferred Shares 7.25% Class AA Series IV (BNA.PR.D). They have very high yields near 5%. Though their credit rating if Pfd-2 low, equivalent to BBB low for bonds, that is still considered investment grade (see Appendix B in this recent Raymond James report on preferred shares). BNA.PR.B and BNA.PR.D look like a very enticing option.

For maturities near 7 years and up to 10 years, corporate bond ETFs, notably BMO's Mid Corporate Bond Index ETF (ZCM), or individual bonds, such as the Great West Lifeco (AA low) 13Aug2020 maturity yielding 3.4% and the Bell Canada (A low) 11Sep2023 yielding 4.6%, become competitive to GICs.

It looks as though there is little benefit to buy very long maturities of 20 years or more as the yield is the same as for 10 years.

The final observation we make is that there is a much steeper increase in yield from 3 to 7 years maturity than at the short end of 1 to 3 years. Fixed income maturities of 5 to 10 years appear to be the best reward vs risk trade-off. If inflation heads back up to 3% or so, which is the top end of the Bank of Canada's target range and thus entirely reasonable to expect, at least the alternatives will keep pace and not lose real purchasing power.

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.

Friday, 6 September 2013

The TSX Composite - Which are the real blue chips?

A "Blue-Chip" stock is supposed to be a solid, dependable, financially sound company that has been around a long time. Let's have a look backwards at the biggest companies on the TSX to see which ones can claim to have performed like a blue chip. We'll go back to 1995 since that is the first year available in the University of Western Ontario annual lists of the TSX Composite Index component companies. Four years ago we did a similar review, so it will be interesting to see how the situation has evolved since. We'll broaden our review to the top 50 companies instead of only the top 25.

The Top 50 in 1995 - Creative destruction at work
The idea of capitalism being a system of creative destruction, where progress happens when the "newer better" replaces the "older less efficient" seems to have been at work on the TSX since 1995. As our table below shows with blue text companies being those still around in 2013 and the normal text being those that have disappeared in one way or another, there has been a lot of change. Less than half - only 23 companies - are still there in their old 1995 recognizable form. Half (25) were bought out or merged into larger entities. Two, in red text - Nortel and Loewen Group - went bankrupt.

The biggest slide in relative market size was BCE Inc (TSX symbol: BCE). Its market cap dropped from 5.07% of the TSX Index in 1995 to 2.25% now. Some 1% of that can be attributed to its spinoff of ill-fated Nortel in 2000 but the company lost ground in the Internet and mobile telephone revolution. Interestingly, it has recovered 0.6% of that lost ground since 2009 so maybe there is hope yet. Perhaps it is finally adapting to the new reality. A couple of other companies have seen their market cap share drop substantially - Barrick Gold (ABX) and Canadian Pacific (CP). In CP's case, some of that decline was due to various spin-offs but part was also due to poor performance of the remaining railway against recently privatized and surging Canadian National Railway (CNR). Barrick just seems to have had poor performance as it combined with #9 Placer Dome and still lost ground.

Another company that has destroyed value is Kinross (not shown at #98 on the 1995 list). It is notable for having acquired two companies - TVX Gold and Echo Bay - in the top 50 and still lost ground.

The greatest destruction happened amongst forestry companies as former giants MacMillan Bloedel (#31), Avenor (34), Abitibi-Price (37) shrank and merged and were bought out. Today there is not a single forestry company in the top 50.

The Top 50 in in 2013 - Banks become more dominant and many new players
"What financial and credit crisis?", the banks and their shareholders might be asking. As our second table below of the top 50 in 2013 shows, all but one (CIBC) of the big 6 banks have gained in relative market weight and rank in the TSX.

The second dramatic change is the arrival in top of the TSX of a whole raft of companies that did not exist or were at the bottom of the table in 1995. Starting with the privatized CNR (later in 1995) currently at number six by market cap and proceeding down through Valeant Pharmaceutical (VRX) whose predecessor Biovail was only first listed on the TSX in 1996, there are no less than 20 companies in the top 50 today that were ranked 200 or below in 1995 (to give a rank difference to those not even present in 1995, we have arbitrarily assigned those companies the lowest 1995 rank of 300). The new entrants are in every sector, except banking, where the dominant players are unchallenged.

Overall there is only a handful of nine companies that lost market cap weight or position from 1995 and still managed to stay in the top 50 in 2013. When a leading company weakens it tends to get bought out.

The Blue Chips - those who have stood the test of time
!) The big banks appear to be the bluest of the blue chips
...  but there are other notables that have been able to improve or hold their position -
2) Suncor (SU)
3) TransCanada Corp. (TRP)
4) Potash Corp (POT)
5) Telus Corp (T)
6) Rogers Communications Inc
7) Encana (ECA)
8) Teck Resources (TCK.B)
9) Power Corporation Canada (POW)
10) Shaw Communications (SJR.B)
11) Fairfax Financial Holding (FFH)
12) Cameco Corp (CCO)
13) Power Financial Corp (PWF)

The big question is whether they will continue to perform or whether some of the new players will prove to be better blue chips for the future. The past may provide some indication of a durable corporate culture and product but it is not a guarantee.

Those who do not want the trouble of trying to figure out which will be the blue chips may simply wish to buy an index ETF, such as the BMO S&P/TSX Capped Composite Index ETF (ZCN), which holds all the TSX Composite Index or the iShares S&P/TSX 60 Index Fund (XIU), which holds the 60 largest companies. These ETFs automatically add and remove those stocks that no longer qualify, giving the average performance of the good and the bad.

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.