Tracking error in currency-hedged funds

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A paper from PWL Capital provides an interesting analysis of tracking error for Canadians who own currency-hedged S&P 500 index funds. Its worth a look if you are apassive index investor.
As Canadian Capitalist pointed outawhile ago, the tracking error on ETFs like the iShares CDN S&P 500 Index Fund (XSP) can be way more than the funds MER. The paper by PWL Capital researcher Raymond Kerzrholooks at the error in currency-hedged S&P 500 funds back to 1980, breaks it down into its components and estimates the size of those components.
There are four components in the tracking error: i) MERs, ii) transaction costs (bid-ask spreads, commissions), iii) interbank interest-rate differentials and iv) residual-currency effect (RCE).
The first two are self explanatory. The third, interest-rate differentials, affect the prices of the currency futures used to hedge currency fluctuations. The fourth, RCE, is the dominant contributor to tracking error; it arises because of lags in the process of updating currency hedging (so thatthe fund is under- or over-hedged for periods of time).
Tracking error can be positive or negative and may be assumed to be offsetting over the long run. But Kerzrho found a systematically negative error in RCE back to 1980 (owing to an inverse correlation between stock and currency changes). This implies that the tracking error on currency-hedged S&P 500 funds will not likely wash out in future periods. The error would likely continue to be negative.
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