Time to step back from the hedge

Holding foreign equity ETFs and index funds means you’re exposed to currency risk. Here’s why that’s a good thing.

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From the April 2014 issue of the magazine.

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If you make regular trips to the U.S. or overseas, the recent decline in the Canadian dollar has probably cost you money. However, it’s been a boon for investors who diversified their investments outside Canada. Since February 2013, the loonie has plunged relative to the U.S. dollar, the euro, British pound and Chinese yuan. So if your portfolio included foreign equities during last year’s bull market, your stocks went up and these currencies appreciated relative to the Canadian dollar. This would have boosted your returns—but not if your funds used currency hedging.

Currency hedging is a strategy many mutual funds and ETFs use to reduce the impact of foreign exchange rates on investment returns. Whenever Canadians hold stocks or other assets denominated in foreign currency, they take on two types of risk. First is the risk the value of the asset itself will fall. A second is that the currency will decline relative to the loonie. Assuming you measure your returns in Canadian dollars, that would result in a loss even if the price of the underlying asset were unchanged. So currency-hedged funds use forward contracts to smooth out any fluctuations in the exchange rate and minimize this latter risk.

Consider what happened in 2009: index funds tracking the S&P 500 returned more than 26% in the U.S., but in Canadian dollars you would have earned only 9%. That’s because the U.S. dollar fell from a high of $1.28 Canadian to $1.05 by the end of that year. If your S&P 500 index fund used currency hedging, however, your return would have been much closer to the one enjoyed by American investors.

Of course, currency risk cuts both ways. When the loonie falls in value relative to the U.S. dollar, Canadians enjoy a bonus, as they did in 2013. The iShares Core S&P 500 ETF (IVV), which trades in New York, returned over 32% in U.S. dollars. That’s a marvellous year by any standards. But the rising U.S. dollar meant a Canadian holding that fund would have enjoyed a return around 41%. Meanwhile, the iShares S&P 500 Index Fund (CAD-Hedged), trading on the Toronto Stock Exchange as XSP, captured the 32% return from the stocks, but forfeited the currency-appreciation bonus because of its hedging strategy.

Index investors have plenty of choices when it comes to currency risk: foreign equity ETFs and index mutual funds are often available in hedged and unhedged versions. So which should you use in your portfolio?

In my opinion, Canadians should stick to funds without currency hedging. While it works in your favour over some periods, hedging is likely to be a losing strategy over the long term.

For starters, it’s expensive and imprecise. One should expect a currency-hedged fund to deliver the same returns to Canadians as its U.S. equivalent delivers to Americans. Since 2005, however, XSP lagged IVV by an average of 1.6 percentage points a year, largely due to inaccurate hedging (it’s reset only once a month). That’s a huge drag on returns when compounded over many years. It’s even worse in taxable accounts: XSP distributed significant capital gains in both 2010 and 2012, largely as a result of trading forward contracts.

If hedging reduced a portfolio’s volatility, it might be worth the added cost. But the opposite is true—at least for Canadians. Our domestic stock market is closely tied to energy and commodity prices, as is our dollar. If Canadians want to take full advantage of U.S. and international diversification, they should hold foreign equities and foreign currencies.

In a 2010 analysis, J.P. Morgan Asset Management found hedging an equity portfolio’s foreign currency lowered volatility for investors in the U.S., U.K., Japan, Germany and Switzerland. But in Canada and Australia (another country whose dollar is closely tied to commodity prices), currency hedging was counterproductive. “The hedge will tend to produce profits at the same time that equity markets are advancing, and produce losses when equities are falling,” the analysts wrote. “Therefore, a currency hedge is not a diversifier within these two countries.”

When making decisions like this, it’s helpful to consider what institutional investors are doing. The Canada Pension Plan manages more than $192 billion of our retirement savings, 60% of which is exposed to foreign currencies. Yet the CPP’s managers use hedging only for the small amount held in foreign bonds. In its 2013 annual report, the Investment Board explained “we see no compelling reason to hedge equity-related currency exposure.”

If you’re not convinced and still want to hedge foreign currency risk you should at least avoid the temptation to make bold predictions about where the loonie is headed. Again, it pays to listen to the smart money: “No one really knows where currencies will go,” writes David Swensen, the superstar manager of the Yale Endowment. “Sensible investors avoid speculating on currencies.”

For more index investing ideas, visit Dan Bortolotti’s Canadian Couch Potato blog.

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