Q: “I use non-hedged ETFs for US and international equities, which worked out well as the Canadian dollar tanked. But the loonie is now so low that I wonder if it makes sense to move to the hedged versions. My thinking that there is limited risk from the loonie falling much further, and a bigger risk from its recovery.” – B.G.
A: It’s hard to believe it was just three years ago that the loonie was at par with the US dollar. Since 2013 our currency has trended steadily downward, reaching a low of $0.68 USD in late January, a level not seen since 2003.
My model portfolios recommend US and international equity index funds that do not hedge their currency exposure. That means when the loonie falls in value relative to the US dollar and other foreign currencies, these funds get a boost in returns. That was particularly dramatic in 2015, when US and international equities posted only modest returns in their native currencies but netted close to 20% for Canadians on the strength of the currency appreciation.
Expecting a repeat of that performance is foolishly optimistic. But neither would I recommend that investors switch to currency hedged funds now, even though these may benefit from a rising Canadian dollar. Here’s why:
Interest rates had to go up, too. A couple of years ago, the most popular question I received from investors was, “Should I avoid bond ETFs given that interest rates are certain to rise?” We all know how that has played out: rates have continued to fall, and anyone who got out of bonds during the last several years has been severely punished. In fact, bonds have handily outperformed Canadian stocks over the last five- and 10-year periods.
Now it’s the weak loonie that apparently has “nowhere to go but up.” Maybe, but the last seven or eight years have shown us such moves are never predictable. I wrote a blog on this subject more than a year ago, remarking at the time that “the Canadian dollar has taken a beating” since mid-2014. Of course, it went on to fall another 10 cents during 2015. Just because it’s near the low end of its historical range doesn’t mean it can’t go lower.
Hedging is unreliable. Currency hedged ETFs often fail to perform as you’d expect. As Justin Bender has shown, the last time the loonie rose sharply the currency-hedged iShares Core S&P 500 (XSP)delivered no benefit at all. From 2006 through 2011 its return was actually a bit lower than that of its unhedged counterparts, even though the Canadian dollar rose more than 14% during that period.
To be fair (hat tip to reader Shaun R. for pointing this out), XSP and Vanguard’s equivalent (VSP) have tracked their indexes far more accurately since the start of 2012. So it’s possible these funds have improved the way they implement their strategy and that their investors really will benefit from a rising loonie. But the jury is still out.
A currency-hedged portfolio is more volatile. One of the biggest misunderstandings about currency hedging is that it reduces risk. In fact, for Canadian investors, the opposite is true. Exposure to the US dollar reduces volatility in a portfolio because the currency has negative correlation with the global equity markets. In other words, when stocks markets around the word do poorly, the US dollar tends to appreciate, which makes for smaller losses in a globally diversified portfolio. While switching to currency hedged ETFs might appear to be removing currency exposure, it’s actually concentrating that risk.
You won’t know when to switch back. And now we come to the biggest problem with switching to currency hedged ETFs. Presumably those who are planning this move don’t intend to make it permanent: once the Canadian dollar recovers, the logical thing to so would be to switch back to the unhedged versions before the cycle repeats. That sounds simple, but is it?
First, what is your target? Will you revert to unhedged ETFs when the loonie gets to $0.90 USD? Or wait until the currencies are at par? Perhaps hanging on past $0.85 USD is pushing your luck. I have no idea, and chances are you don’t either. Maybe you’ll just wait until it “feels right.”
Trying to time currencies no different from any other tactical move: you need to be right on the way in and on the way out, and you probably won’t be. Indeed, most investors who engage in this kind of activity have only a vague idea of when they will reverse the trade, and even those with a process can fall prey to their emotions and fail to pull the trigger.
Finally, let’s not forget that even if you end up getting the timing right and the hedged ETFs track their indexes perfectly, transaction costs and capital gains taxes can still take a significant bite out of your profits.
So instead of switching between hedged and unhedged ETFs, I suggest a more humble approach. Build a global equity portfolio with unhedged ETFs (which offer better diversification and tighter tracking error) and stick to your plan, even when it feels like it’s not working. Accept that there will always be periods when currencies (just like bonds and stocks) fall in value—that’s the why we diversify. And when foreign currencies juice your returns, as they have recently, take the opportunity to rebalance your portfolio, just as you would if the gains came from the underlying stocks.
When investors talk about switching their hedging strategy these days, they often add a comment like, “I know we shouldn’t time the markets, but…” The insight comes when you realize there’s no but. Whether it’s currencies, interest rates, or stocks, the markets have a way of humbling anyone who tries to guess their next move.
This article originally appeared on The Canadian Couch Potato.