Trading U.S. securities implies foreign exchange rate risk. Canadian dollar hedged funds offer investors some protection of equity returns when exchange rates fluctuate.
The Stock: iShares Russell 2000 Index Fund- CAD Hedged (XSU-T) Recent price: $17.80
The Trend
Canadian investors have enjoyed good returns during the current bull
market, with the domestic stock market outperforming U.S. stocks
throughout the period. However, the relative performance of U.S.
equities has improved enough that Canadians should consider expanding
their exposure south of the border. Of particular interest is the
small-capitalization sector, which has been eclipsing the performance of
the bigger stocks in the S&P 500 index since the end of the third
quarter last year.
The Russell 2000 index is the traditional benchmark for U.S. small-cap
stocks. It is up 14 per cent from three months ago, ahead of the
11-per-cent advance in the broader U.S. market. About 35 exchange-traded
funds offer various ways to play the U.S. small-cap sector. Last week,
all but two of these ETFs reached new 52-week highs, including the
heavily traded iShares Russell 2000 index fund as well as the
top-performing Vanguard Small Cap Growth fund, up 17 per cent in the
past three months.
Small-cap Canadian equities are also doing well, signalled by the TSX
Venture Exchange index outpacing the S&P/TSX composite index by 9 per
cent during the winter's stock market advance. However, small-cap stocks
on the Venture Exchange and the TSX are largely resource plays, so their
recent performance premium is largely a reflection of the speculative
strength of the commodity trade.
The Trade
The relative strength of the U.S. market may seem inviting to Canadian
investors, but currency risk is a real concern. A strong and rising
loonie eats away at the returns from U.S. stocks. But the iShares
Russell 2000 CAD Hedged index fund, traded on the Toronto Stock
Exchange, hedges its currency exposure and provides insurance against
the chance the loonie may continue to rise.
An example of the hedging advantage of this fund can be found when
comparing the performance of the unhedged Russell 2000 index against
this iShares fund. Over the past three months the Russell's
14.3-per-cent gain would have been partially offset by a 2.3-per-cent
rise in the Canadian dollar versus the greenback and resulted in a
12-per-cent return. In contrast, an investor in the Shares Russell 2000
index CAD Hedged fund would have retained a 13.1-per-cent gain.
The Upside
The Russell 2000 is just 4 per cent shy of its pre-recession high. Trend
investors can expect a bullish stock market to help blast through that
long-term overhang and will be anticipating a 10-per-cent gain from the
current level as the index moves along its current trend line.
The Downside
All the factors that threaten the U.S. stock market can doubly affect
small-cap stocks. A surging U.S. dollar also means bad news for this
trade, since Canadian-dollar-hedged instruments lag the unhedged index
when the loonie drops. This fund would turn Stock Trends Weak Bullish at
$16.50, a possible exit point for this trade if the market turns.
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