Impacts of currency fluctuations and currency hedging on returns

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Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

Over the last 12 months (as of the end of April), the S&P 500 (VOO) has been on fire accumulating a total return of 17%. Even more impressive is the return of the S&P 500 for a Canadian investor. Over the same period, VFV (which is equivalent to VOO expressed in Canadian dollars) had a total return of 28%, 11% more!

Sometimes, the reverse effect happens. In 2016, from the beginning of the year until the end of April, VOO totaled a gain of 1% while VFV totaled a loss of -8%, 9% less!

Obviously, the impact of currency fluctuations can be pretty significant on the returns of foreign investments.

Many ETF providers offer currency-hedged versions of their international funds to remove the impact of currency fluctuations on returns. How effective is this hedging?

Interestingly, Vanguard Canada provides two ETF wrappers around VOO, one with currency hedging (VSP), and one without (VFV). Given that they now have a little over four years of existence, we can look at their track record. Here's a chart of:
  • S&P 500 in Canadian dollars, currency-hedged: VSP (in blue),
  • S&P 500 in Canadian dollars, no currency hedging: VFV (in red), and
  • S&P 500 in U.S. dollars: VOO (in orange).
Period: November 30, 2012 to April 30, 2017
Source: PortfolioVisulalizer
vsp-vfv-voo.png
Over this period, VFV was able to deliver an impressive annualized return of 22.83% while VSP and VOO delivered more modest annualized returns of 14.35% and 14.89%, respectively. One could attribute the small difference in returns of approximately 50 basis points between VSP and VOO to three things:
  1. The 15% U.S. withholding tax on VUS dividends,
  2. the higher MER, and
  3. the cost/impact of currency hedging.
But, it is disturbing to see that VSP almost perfectly tracked the returns of VOO until the end of 2015, but since 2016, a small divergence has developed. Is this an accident?

To investigate this, I've decided to give a look at another S&P 500 ETF with a longer history: XSP. Here's a comparison of VSP and XSP:
  • S&P 500 in Canadian dollars, currency-hedged: VSP (in blue), and
  • S&P 500 in Canadian dollars, currency-hedged: XSP (in red).
Period: November 30, 2012 to April 30, 2017
Source: PortfolioVisulalizer
vsp-xsp.png
Let's call this a perfect match.

As VOO is younger than XSP, I'll use the mutual fund version of Vanguard's S&P 500 (VFIAX), instead, to get the longest possible comparison. But, we must be careful. Before november 15, 2005, XSP did not provide currency hedging. So, we'll limit our comparison to the period after the change. Here's the result:
  • S&P 500 in Canadian dollars, currency-hedged: XSP (in blue), and
  • S&P 500 in U.S. dollars: VFIAX (in red).
Period: November 30, 2005 to April 30, 2017
Source: PortfolioVisulalizer
xsp-vfiax.png
Over the period, VFIAX delivered an annualized return of 8.07% while XSP provided an annualized return of 6.40%. That's a pretty significant difference, not entirely explainable by the the 15% withholding tax on dividends, the higher MER, and the cost of hedging.

But, it's hard to see where the problem was on the growth chart.

[To be continued...]
Last edited by longinvest on 14 May 2017 06:39, edited 3 times in total.
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

[...Continuing.]

It is much easier to see the differences on a Bogle Telltale chart, which displays the difference in returns between two funds. In the following chart, the horizontal 1 line represents VFIAX. The blue line goes down when XSP does worse than VFIAX and up when XSP does better than VFIAX. At the right end of the chart, we see that XSP is down to 84% of VFIAX's value, lagging by a cumulative 16%.
xsp-vs-vfiax.png
Now, we can see things more clearly. From December 2005 to October 2008, XSP suffered a relatively steep but regular drag in returns (probably the 15% withholding tax plus the cost of hedging).

But, then, between november 2008 and January 2009, derivatives did what they unfortunately do, sometimes, in the worst of times; they failed!

After that episode, the steep but regular drag started back and did not slow down until Vanguard came to Canada in late 2011 and introduced VUS (U.S. total market, currency-hedged). Magically, iShare's hedging started to become more efficient. Interesting. :!: Is it a coincidence? Probably, as we can see the steep and regular drag reappearing in 2016. As we've seen in the previous post, Vanguard's currency-hedged VSP is unfortunately experiencing the exact same drag. :?

Conclusions?

Seeing how currency hedging failed in bad times comforts me in my decision to avoid derivatives in my portfolio. I think that what happened in 2008 completely rules out, for me, any idea of ever including currency-hedged ETFs, specially currency-hedged bond ETFs such as Vanguard Canada's VBU (U.S. bonds, currency-hedged) and VBG (World ex U.S. bonds, currency-hedged), in my portfolio.

Also, seeing the extent of the impact of currency fluctuations on foreign investment returns comforts me in limiting foreign investments to 25% of my portfolio. These fluctuations are due to short-term concerns affecting the supply and demand for currencies, often unrelated to the portfolio's foreign investments. Yet, I can easily understand that others, specially those who often travelling abroad, might feel differently about this.

What do you think?
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

Here's what the Management Report of Fund Performance (MRFP) for the year ended on December 31, 2008 had to say about it:
Results of Operations

[...]
For the year ended December 31, 2008, XSP returned -40.33% versus the Index return of -39.02%. The main reasons for the difference in performance of 1.31% between XSP and the Index were trustee fees (-0.24%), and other miscellaneous factors (-1.07%). The performance of XSP relative to its benchmark index is affected by, among other things, withholding taxes paid on dividend income and the volatility of currency markets and equity markets. Sound management of currency hedges may result in trades taking place at slightly different times than the times assumed by index providers. The effect of these timing differences on performance is greater during periods of high volatility, such as that experienced in 2008.
It's the timing of hedging operations due to sound management that caused XSP to fail matching its index.

Does this mean that better currency hedging would require reckless management?
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

I find it even more disturbing that the difference between XSP and its index in 2008, due to the difference in hedge operation timing, was only -1.07. Our telltale chart tells us that XSP experienced a rapid drop of relative to the return of VFIAX in U.S. dollars. In other words, the erratic behavior was embedded into the index XSP tracks!

The total return of the S&P 500 in 2008 was -37.00%. The total return of XSP's index was -39.02%. That's a difference of more than 2%. Over the last 10 years, XSP trailed the return of the S&P 500 (in U.S. dollars) by an annualized -1.55%, while it "only" trailed its own index by -0.70%. Meanwhile, during the same 10 years VFIAX trailed the S&P 500 by an annualized -0.01%.

I think that there is something wrong in the choice of index of currency-hedged index ETFs. I think that the proper index should track the market in local currency, not in Canadian dollar through a layer of derivative hedges hiding the risks and impacts of the derivatives (specially during periods of high volatility).
Last edited by longinvest on 14 May 2017 16:16, edited 1 time in total.
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

While at it, let's check if the index of an unhedged ETFs displays the same kind of discrepancies.

Let's take VFV. As of December 31, 2016, it's index had a trailing 3-years annualized return of 17.66%. During the same period, the annualized return of the S&P 500 was 8.87%.

VFV itself had an annualized return of 17.30% over these three years. The ETF it wraps (VOO) paid an average 2.20% per year in distributions over the period. As a consequence, the U.S. 15% tax withholding should have reduced VFV's return by 2.20% X 15% = 0.33% relative to its index. 17.66% - 0.33% = 17.33%. The remaining difference of 0.03% is smaller than VFV's MER. Not bad.

The exchange rate of the Canadian dollar on December 31, 2013 was 1 CAD = 0.94095 USD (source). On December 31, 2016, it was 1 CAD = 0.74383 (source).

Let's put this all together. An investment of 10,000 USD in the S&P 500 on December 31, 2013 would have grown to $12,904 on December 31, 2016. That's equivalent to investing 10,628 CAD on December 31, 2013 and getting back 17,348 CAD on December 31, 2016. The annualized return, in Canadian dollars, was thus (17,348/10,628)^(1/3) - 1 = 17.74%.

There's a difference of 0.08% between the return of the S&P 500 in Canadian dollars (using the above calculations) and VFV's index return.

This seems close enough, but the last three years were not a period of high volatility. Should I be worried about this small difference?
Last edited by longinvest on 14 May 2017 09:38, edited 1 time in total.
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by Shakespeare »

http://www.pwlcapital.com/pwl/media/pwl ... _10_21.pdf
I conclude that currency hedging can be far more expensive than expected.
Most of these costs can be attributed to the unforeseen but significant technical challenges involved in
effectively hedging an equity portfolio. Institutional and retail investors are equally exposed to these high
costs.
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

The disturbing thing is how the chosen index hides more than 50% of the overall tracking error (XSP's -0.70% error against its own index versus -1.55% against the S&P 500).

But, unhedged ETFs have a problem of their own. Over the last 3 years, a U.S. investor putting $10,000 into the S&P 500 made a cumulative gain of 29%. Meanwhile, a Canadian investor putting $10,000 in the S&P 500 made a cumulative gain of 63% (before taxes and MER). That's an additional 34% above the gain of the U.S. investor while investing into the same thing, just because of currency fluctuations. That was just plain luck, for the Canadian investor. It had nothing to do with the soundness of his investment. It could have gone into the other direction, and it will probably do, at some point. We're not talking about a mild impact, here.

Am I the only one worrying about such things?
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by Shakespeare »

Unhedged ETFs have lower costs and should be favoured for that reason alone. Currency fluctuations in the long run cancel out and can be addressed by the split between Canadian and foreign equities.
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by Peculiar_Investor »

longinvest wrote: 14 May 2017 09:56 Am I the only one worrying about such things?
I think longtime FWF'ers have previously done the analysis and figured out it isn't worth the worrying, as best summed up by ...
Shakespeare wrote: 14 May 2017 10:08 Unhedged ETFs have lower costs and should be favoured for that reason alone. Currency fluctuations in the long run cancel out and can be addressed by the split between Canadian and foreign equities.
:thumbsup: :thumbsup:

That doesn't make the discussion any less valuable, it is still very valuable for newer members and lurkers who might not have done the research and analysis for themselves. For that we should all thank you for your time and efforts to educate. :thumbsup: :thumbsup:
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

Shakespeare wrote: 14 May 2017 10:08Currency fluctuations in the long run cancel out
Is that a promise? I can find a few currencies for which this doesn't seem to have panned out, such as the Mexican Peso (in one direction) or the Japanese Yen (in the other).

(source)
usd-jpy.png
Shakespeare wrote: 14 May 2017 10:08can be addressed by the split between Canadian and foreign equities.
Maybe, but that runs contrary to the principle of pure market-weighted indexing, where one would only put 3% of his stock allocation in Canada's stock market.

Let's be clear. I am with you, here. I have split my stock allocation 50/50 between Canada and the rest of the world, exactly because I wanted to have no more than half of my stock allocation exposed to currency fluctuations. But, by doing so, I am taking a lot of concentration risk into an undiversified market. Concretely, I'm putting 3.6% of my stock allocation into the Royal Bank of Canada when its weight is a mere 0.22% of the world's stock capitalization.
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Re: Impacts of currency fluctuations and currency hedging on returns

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Longinvest, I am a firm believer in what Shakes said
Unhedged ETFs have lower costs and should be favoured for that reason alone. Currency fluctuations in the long run cancel out and can be addressed by the split between Canadian and foreign equities.
and perhaps that is my bias based on my sole experience in about 30 years of investing.

True that Japan has been an exception but it is, in my opinion, totally self-inflicted. If Japan would get out of a state of denial AND become culturally inclusive, they could have revived their economy long before now. When a country advocates protectionism, and shuts out immigration to the point of causing a shrinking population with an increasingly aged demographic, it is a model for economic decline.

I think we can reasonably say Canada has a better chance of maintaining a neutral currency position over 15-30 year cycles with our free trade and immigration policies, albeit I see further near term decline in our loonie until Canada is seen to better support GDP growth through sronger private and foreign investment.

Added: My Cdn equity allocation 'on the surface' looks way too high but in reality it is not nearly the case. The vast majority of my holdings are in Canadian companies with a significant foreign presence and I plan on keeping it that way. I have little faith in Canada's current direction.
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Re: Impacts of currency fluctuations and currency hedging on returns

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AltaRed wrote: 14 May 2017 10:39 True that Japan has been an exception but it is, in my opinion, totally self-inflicted. If Japan would get out of a state of denial AND become culturally inclusive, they could have revived their economy long before now. When a country advocates protectionism, and shuts out immigration to the point of causing a shrinking population with an increasingly aged demographic, it is a model for economic decline.
The thing is that, as an individual investor, I have no control over the political culture of my government. Our dollar could go the way of the Yen or that of the Peso, and I would have no more control than casting a single vote every 5 years. Not very comforting.
AltaRed wrote: 14 May 2017 10:39 I think we can safely say Canada has a better chance of maintaining a neutral currency position over 15-30 year cycles with our free trade and immigration policies, albeit I see further near term decline in our loonie until Canada is seen to better support GDP growth through sronger private and foreign investment.
My own idea, about it, is that our currency is unlikely to do too badly over the long term due to the Bank of Canada's monetary policy of trying to keep inflation stable by controlling interest rates and letting our currency fluctuate (in the short term). The inflation target should limit the extent of long-term fluctuations. But, I might be wrong, or the Bank of Canada could change its monetary policy with the government's approval in the future.

I admit that my above idea is just pure speculation. I simply don't know what the future holds for our currency.
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Re: Impacts of currency fluctuations and currency hedging on returns

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AltaRed wrote: 14 May 2017 10:39 Added: My Cdn equity allocation 'on the surface' looks way too high but in reality it is not nearly the case. The vast majority of my holdings are in Canadian companies with a significant foreign presence
That sounds similar to Jack Bogle's contention that U.S. investors don't need international investments, because U.S. companies make a big part of their business abroad.

Is owning GM the same as owning Toyota? I'm not sure.
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Re: Impacts of currency fluctuations and currency hedging on returns

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longinvest wrote: 14 May 2017 11:00 That sounds similar to Jack Bogle's contention that U.S. investors don't need international investments, because U.S. companies make a big part of their business abroad.

Is owning GM the same as owning Toyota? I'm not sure.
I wouldn't equate GM with Toyota (albeit you are likely buying some similarity in geographic weightings - albeit with GM tilted to USA and Toyota a broader global balance), BUT to the extent one wants to buy a Canadian stock rather than a foreign stock, buy Magna International... and avoid undue concentration in a potentially underpeformer (Canada). My point simply was one's Canadian equity allocation percentage does not need to imply Canadian economy concentration.

FWIW, my opinion is that unless we have a return to the super commodity cycle and have the balls to invest in our economy such as ports and pipelines and railways to take advantage of that super commodity cycle, and unless we are prepared to invest to protect (and maybe develop) our northern resources, we are likely to roll around in the ditches for decades to come.
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Re: Impacts of currency fluctuations and currency hedging on returns

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AltaRed wrote: 14 May 2017 13:24 FWIW, my opinion is that unless we have a return to the super commodity cycle and have the balls to invest in our economy such as ports and pipelines and railways to take advantage of that super commodity cycle, and unless we are prepared to invest to protect (and maybe develop) our northern resources, we are likely to roll around in the ditches for decades to come.
If that's your firm belief, then your problem could be solved easily: put your money in VXC or XAW (or in VFV, if you don't want to risk the money out of the S&P 500). They should deliver more than their underlying markets as our dollar goes into the ditches for decades to come too. :wink:
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

More seriously.
AltaRed wrote: 14 May 2017 13:24 My point simply was one's Canadian equity allocation percentage does not need to imply Canadian economy concentration.
Yes, this makes sense. But, putting one's money in a few Canadian companies (doing business abroad) remains a high concentration in a very small portion of the world's stock capitalization. This is what I meant by concentration. (I know, it's an unsolvable problem; it's annoying).
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Re: Impacts of currency fluctuations and currency hedging on returns

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longinvest wrote: 14 May 2017 13:34 If that's your firm belief, then your problem could be solved easily: put your money in VXC or XAW (or in VFV, if you don't want to risk the money out of the S&P 500). They should deliver more than their underlying markets as our dollar goes into the ditches for decades to come too. :wink:
I do have a very significant holding in XWD (before the days of VXC or XAW). My single largest holding and then comes VTI, VTV, VGK and XEF in that order. Were I to start over, it might just be VXC and VTI (will always be preferentially weighted to the USA).

It isn't that hard to be fully market cap weighted with equities. I recall that George Hariton does that.
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Re: Impacts of currency fluctuations and currency hedging on returns

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AltaRed wrote: 14 May 2017 14:10 I do have a very significant holding in XWD (before the days of VXC or XAW).
XWD is a very interesting investment, if it wasn't for its relatively high 0.47% MER. That's one thing I really dislike about BlackRock; instead of lowering the MER on their existing ETFs, they introduce new ones. That's the main reason I am staying with VXC instead of putting new money into XAW, despite it's higher MER and less advantageous tax structure. As my VXC holding is in taxable, I have more confidence in Vanguard lowering the MER in the future, due to economies of scale, than BlackRock doing it.

From an investing point of view, they are still pretty much all the same:

Period: February 28, 2015 to April, 30 2017
XWD, VXC, XAW
Source: PortfolioVisualizer
xwd-vxc-xaw.png
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Re: Impacts of currency fluctuations and currency hedging on returns

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As we all do with legacy ETFs, we are shackled by our unrealized cap gains. My XWD holding has 6 digits of unrealized cap gains. Have to tough the (relatively) high MER out. First world problem really.
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Re: Impacts of currency fluctuations and currency hedging on returns

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AltaRed wrote: 14 May 2017 14:10 It isn't that hard to be fully market cap weighted with equities. I recall that George Hariton does that.
Pretty well. I still have a legacy holding of QQQ that I am slowly whittling down: It's what I sell when I need some money.

I've stated elsewhere that I believe that holding VTI, VEA and VWO, and not hedging currencies, is a desirable form of diversification. That's how I view the last few years in equity markets. Holding equities X-Canada without hedging to CAD has smoothed out the ups and downs of each component.

More generally, I agree with the opinions that it is impossible to predict foreign exchange rates. On the other hand, Canada is a small, open economy overly dependent on natural resources and commodities. Hence its currency is bound to be very volatile against the USD or against a basket of foreign currencies. Avoiding that volatility is very easy and doesn't cost me anything -- indeed it saves me money (hedging and wrapper fees).

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Re: Impacts of currency fluctuations and currency hedging on returns

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Re: Impacts of currency fluctuations and currency hedging on returns

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We have made out very well with the MXN. Bought our condo in 2007 when the C$ was at a 6.5% premium.

Watched the pesos move from 11.31 to 13.68 even though some prices have adjusted upwards. We still consider ourselves to be ahead by purchasing in the local economy (avoiding gringo-priced places). This is a 10 year view.

Like AR, we think the FX is well-handled by our multinational stock holdings. Including some direct US stock holdings. We have unloaded our direct holdings in Europe and elsewhere through ADRs. We now hold funds to cover those markets.
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

Quebec,
I think that there's an error in the title of that subsection. It should read: "Currency fluctuations have evened out over several decades, so far". To tell the truth, I really don't find that subsection of the wiki page on currency hedging convincing at all.

I would be willing to be convinced by an argument about purchase power parity over the long term*. The problem I raised in the OP remains, though. In the short term, currency fluctuations can have a very significant impact on returns. We've been extremely lucky, lately, that the impact was a significant boost in returns for U.S. investments which were already on fire.

* In the long term, we're all dead, too. So, we might not have the opportunity to wait long enough.

But, if you were to look at it from the other side, the picture is pretty bad. U.S. investors investing abroad have been experiencing pretty bad returns for the last 20 years. Here's a chart of U.S. bonds (VBMFX) in blue and World ex US stocks in red, since the inception of Vanguard's Total International Stock Index Fund (VGTSX):

Source: PortfolioVisualizer
vbmfx-vgtsx.png
We're not talking about the so-called "bond bubble", here. Bonds only had (pre-tax) inflation-adjusted annualized 3% returns over the period. Yet, a 100% stocks investment in World ex US markets delivered lower returns along with mind boggling volatility.

Don't forget that when we invest abroad, we're seen as the bad guys and gals by (almost) everybody. We're seen as invaders by foreigners (thus foreign withholding taxes). As for our own fellow citizens, they see us as traitors trying to hide money abroad (bringing us the pleasures of Form T1135, and double taxation due to missing dividend credit). We're likely to continue to be penalized, domestically and abroad, on these investments, regardless of how they perform.

If I was experiencing the same risks and returns as foreign investors, when investing into their markets, I would adopt world market weightings in my portfolio (e.g. limit Canada exposure to 3% of stocks). But, that's not the case. Just think about it; why don't we include a world market weighting of unhedged international bonds in our portfolios? If the risks were no bigger than domestic bonds, and we were experiencing the same (low) risks and (low) returns as foreign investors in those bonds, there would be no reason to avoid them.
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Re: Impacts of currency fluctuations and currency hedging on returns

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longinvest wrote: 14 May 2017 20:23 Just think about it; why don't we include a world market weighting of unhedged international bonds in our portfolios? If the risks were no bigger than domestic bonds, and we were experiencing the same (low) risks and (low) returns as foreign investors in those bonds, there would be no reason to avoid them.
Costs are significantly higher for international bonds.
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longinvest
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

adrian2 wrote: 14 May 2017 20:43 Costs are significantly higher for international bonds.
How so?
Variable Percentage Withdrawal (finiki.org/wiki/VPW) | One-Fund Portfolio (VBAL in all accounts)
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