A Twist: Currency Neutral Funds

 

In Step 4c: Investing with TD Direct Investing I just mentioned four TD e-series funds, but you may notice that on the complete list of e-series funds on TD’s website that for US and international equity funds there are at least two versions: one denominated in Canadian dollars, and another one also in Canadian dollars but called “currency neutral.” Many ETF providers also have currency neutral versions of their funds. These currency neutral funds attempt to eliminate the change in valuation between the Canadian dollar and the US dollar (or, for the international fund, the Canadian dollar and a basket of foreign currencies like the pound, euro, yen, and Australian dollar).

If you’ve ever gone cross-border shopping in the US then you’re probably well aware of the exchange rate, and also that it changes over time. Those changes in the value of the Canadian dollar relative to other currencies don’t only affect the price you pay for goods, but also for stocks. If the US S&P 500 index goes nowhere for a year, but the Canadian dollar goes up by 5%, then your investment in US stocks would actually be worth 5% less if you had to sell. Vice-versa, if the Canadian dollar goes down that would increase your returns. The currency neutral investment would only give you (in theory) whatever the S&P 500 returned, without the added effect of the changing Canadian dollar.

I say in theory because this currency hedging usually costs something, and that cost is not counted in the MER listed. It costs up to 1% per year for the hedging: that cost appears in what is known as “tracking error.” Because currency fluctuations are usually manageable in the long term, and because one direction of currency fluctuations (the Canadian dollar weakening) is good for your foreign investments, it’s usually recommended that long-term investors not bother with currency neutral funds.

However, in the short term changes in the dollar can be almost as extreme as changes in stock prices, so in some situations it may be worthwhile to consider the currency neutral version of the funds. Mostly, that would be where you have an intermediate time horizon: long enough to still maintain an equity exposure, but short enough that currency moves may not average out. My rule-of-thumb would be about 3-7 years – and you don't have to make your entire portfolio currency neutral.