Why Currency Hedging Doesn’t Work in Canada

In the last two years, Canadian ETF providers have finally launched US and international equity ETFs that do away with currency hedging. Yet the strategy remains hugely popular: the hedged versions of Vanguard’s international and US total market ETFs remain much larger than their unhedged counterparts, while investors have more than $2 billion in the iShares S&P 500 Hedged to CAD (XSP), making it the third largest ETF in Canada.

None of my model portfolios include currency-hedged funds: I’ve long argued the strategy is expensive and imprecise. Even when the Canadian dollar appreciates strongly, the high tracking error of currency-hedged funds often reduces any potential benefit. In one dramatic example, Justin Bender looked at the period from 2006 through 2011, when the US dollar depreciated by almost 13% and hedging should have produced a huge boost: in reality, XSP lagged its US-listed counterpart.

This leads to an interesting question. If currency hedging were free and precise—with an expected tracking error of zero—would it be worth considering?

Does hedging lower volatility?

The most common argument in favour of currency hedging is that it lowers volatility. In Unconventional Success, David Swenson—the legendary manager of the Yale Endowment—explains that currency diversification is a benefit, but only to a point. He says one should hedge foreign currency once it exceeds 25% of the portfolio’s assets: “Beyond a quarter of portfolio assets, the currency exposure constitutes a source of unwanted risk.”

Other studies also suggest too much foreign currency exposure creates more volatility with no increase in expected returns—which is, of course, a lousy combination. A research paper prepared for the IMF looked at data for France, Germany, Japan, the United Kingdom and the US, concluding that “currency hedging appears to effectively reduce the variance of foreign investment returns not only at short investment horizons but also at horizons of up to 5 years in most cases.”

These findings will likely raise the eyebrows of investors who use my model portfolios, which have as much as 40% exposure to foreign currency. Wouldn’t it make sense to hedge at least part of the US or international equity holdings? No, it wouldn’t. It turns out the idea that hedging lowers volatility simply doesn’t hold up in Canada.

A couple of industry white papers—one Canadian and one American—have provided evidence to support this idea. Exhibit A comes from Pyramis Global Advisors: their research looked at data from 1990 through 2009 and found that for Canadians a fully unhedged portfolio had the lowest volatility: hedging half the foreign currency increased the annual standard deviation of returns, and hedging all the currency bumped it even higher.

In another analysis, researchers at J.P. Morgan Asset Management looked at the effect of hedging on investors in the US, Japan, the United Kingdom, Germany, Switzerland, Australia and Canada. They found hedging at least part of an equity portfolio’s foreign currency risk lowered volatility in the first five countries, but in Canada and Australia the strategy was counterproductive. “A currency hedge is not a diversifier within these two countries,” they wrote.

Loonie tunes

Why isn’t hedging effective in Canada? The Pyramis researchers explain that the US dollar, euro and Swiss franc tend to have negative correlation with the global equity markets. (Recall that when all risky assets plummeted in 2008, the US dollar soared.) Negative correlation is what diversification is all about: any part of your portfolio that goes up when equities go down is a welcome addition, so exposure to these currencies is a benefit, and hedging wipes it out. As the J.P. Morgan authors write: “The hedge will tend to produce profits at the same time that equity markets are advancing, and produce losses when equities are falling.” In other words, it magnifies volatility rather than reducing it.

Still not convinced? The Canada Pension Plan offers another commentary in its 2013 annual report. The CPP Investment Board sees “no compelling reason to hedge equity-related currency exposure,” largely because “hedging would unduly tie Fund returns to the price of oil and other commodities as they drive the foreign exchange value of the Canadian dollar.” (Incidentally, that explanation helps explain why hedging is equally dubious in Australia, where the dollar is also correlated with commodity prices.)

The evidence seems clear that hedging is a costly strategy that actually increases risk and frequently fails to offer a benefit even when the Canadian dollar appreciates. How long before the popularity of currency-hedged index funds finally wanes?

28 Responses to Why Currency Hedging Doesn’t Work in Canada

  1. Francis March 6, 2014 at 9:37 am #

    “The hedge will tend to produce profits at the same time that equity markets are advancing, and produce losses when equities are falling.” In other words, it magnifies volatility rather than reducing it.

    So I guess hedging work great on US Bond according to that statement.

  2. Gerry P March 6, 2014 at 3:27 pm #

    Since bond funds are in a portfolio to reduce stock market risk, and also since they tend to be negatively correlated to equities, would your conclusions about hedging for Canadian investors also apply to bond funds?

  3. Canadian Couch Potato March 6, 2014 at 3:34 pm #

    @Francis and Gerry: The general rule is to avoid all currency risk with fixed income. So if your portfolio happens to include US corporate bonds or emerging market bonds (which are usually denominated in USD), then hedging would be appropriate. Otherwise the stabilizing role of bonds could be completely undermined by currency volatility:
    http://canadiancouchpotato.com/2012/03/01/ask-the-spud-should-i-hold-us-bonds/

    For the record, the CPP hedges all foreign currency on the fixed income side for this reason.

  4. AJ March 6, 2014 at 7:39 pm #

    What timing. I just came on this site to see what you had to say about hedging because 5 minutes ago I was trying to figure out which TD e-series fund to invest in: TD U.S. Index fund or the TD U.S. Index Currency Neutral fund, the latter being the one that is hedged. As it turns out, the MER of the hedged fund is 0.51%, compared to 033% for the non-hedged fund. If I understand your article correctly, even if the MER’s were the same, the non-hedged fund would still be the better choice? If so, the higher MER makes it a no brainer.

  5. Canadian Couch Potato March 7, 2014 at 12:11 am #

    @AJ: In my opinion, yes, even if the costs were the same (as they are for the hedged and unhedged Vanguard ETFs, for example) the unhedged versions are still the better choice for the reasons described in the post. It’s not just a matter of cost: the problem is the hedge actually reduces the diversification benefit offered by foreign equities.

  6. Andrew F March 7, 2014 at 10:19 am #

    What about the cost of hedging with bond funds? Given that bonds are less volatile, we should expect less compounding of tracking errors.

  7. Adam C March 7, 2014 at 10:21 am #

    Great article. I think another potential reason unhedged might be more beneficial is if one intends to travel in retirement to the countries whose currencies are owned. Protects your investments against any relative canadian dollar devaluation that would make travel overly expensive.

  8. Canadian Couch Potato March 7, 2014 at 10:29 am #

    @Andrew F: That sounds reasonable, though I have not looked closely at Canadian-listed ETFs that hold USD-denominated bonds to see how accurate the hedging is. It would have to be precise or any incremental benefit from owning foreign-denominated bonds could be wiped out.

  9. Smithson March 7, 2014 at 8:59 pm #

    @CCP: Do you think that there is an argument to be made for increasing the hedging of the equity component of your portfolio as you get closer to retirement? I would think that if you are going to spend your retirement in Canada then you would want to reduce foreign currency exposure as you get older.

  10. Oldie March 8, 2014 at 1:34 am #

    @Smithson: So I’m still trying to get a feel for this hazard. That is, you are proposing to hedge to minimize the currency risk superimposed upon the equity risk. I am trying to see the justification for hanging on to foreign equity in retirement (assuming your intent to spend the money in Canada soon). It would seem to me that the risk of holding substantial equity, let alone the risk of foreign equity requiring hedging is inappropriate given a diminishing investment time horizon. Or have I missed something?

  11. Smithson March 8, 2014 at 2:39 am #

    @Oldie: When I retire, the equity component of my portfolio will be smaller than it is currently, but I will still have foreign equities as well as Canadian equities. The reason for this is to stay diversified. Also, Canada still only represents 4% of the global equity market. The question I am wondering about is if I should hedge the foreign equities after retirement.

  12. Canadian Couch Potato March 8, 2014 at 9:38 am #

    @Smithson: I don’t think the situation changes in retirement. Any money you expect to need in the next five years or so should not be in equities at all, and if your time horizon is long enough to take equity risk it’s also long enough to accept currency risk.

    Remember, too, the main idea, which is that an all-Canadian equity portfolio is likely to be more volatile than one that includes foreign currency exposure, so hedging would actually add risk in retirement, not reduce it.

  13. Oldie March 8, 2014 at 10:29 am #

    @CCP: So, would this be a reasonable ranking of portfolio risk for Canadian investors?

    All Canadian Equity Only>
    Canadian Equity+Global Equity, Hedged>
    Canadian Equity+Global Equity, Unhedged

    I was trying to understand from your article whether or not US equities should be included in your recommendation NOT to hedge on Global Equities, and wasn’t able to sort out the information. The fact about US dollar tending to have negative correlation with global markets is only relevant to US Investors, right? (i.e. if our Global ETF is priced in USD it doesn’t affect or protect our Canadian Dollar return from the fluctuations in the currencies of the countries the equities are invested in). So would NOT hedging US equities also be part of the recommendation (assuming efficient and accurate hedging was available)?

    Also, given that negative correlation of CAD with Global Equity markets basically is the underlying driver of this protective effect, and that correlations negative or positive tend to drift over time, would we be wise to re-check the validity of this strategy every half decade or so?

  14. Almost retired March 8, 2014 at 11:11 am #

    @ccp Re your comment : “Any money you expect to need in the next five years or so should not be in equities at all.”

    What’s your view on this with regard to projected dividend payments? Simple scenario:

    Projected cash need 5 yrs: $45,000
    Dividends projected current payout rate 5 yrs: $25,000
    Near cash holdings $20,000

    While it’s possible dividends will be cut others may increase to offset. Would you support this approach?

  15. Canadian Couch Potato March 8, 2014 at 11:54 am #

    @Oldie: The advice to avoid hedging applies to US as well as international holdings. If there is negative correlation between the US dollar and the global markets, this would benefit Canadians more than Americans: for example, in 2008, when markets plummeted around the world but the US dollar rose, Canadians who had USD exposure lost less than they would have without that currency exposure.

    I suppose you could could check the correlation every few years, but that would not tell you anything about what to expect in the future.

    @Almost retired: Do you mean your cash requirement is $45,000 annually, or $45,000 in total over 5 years ($9,000 annually)? If it’s the former, then my feeling is that there is too much risk involved in keeping less than six months’ worth of cash on hand in retirement. Dividend payments may be quite reliable, but I would still want a buffer of about two years’ worth of cash.

  16. Oldie March 8, 2014 at 5:32 pm #

    @CCP: Thanks, I’m clear now that Canadians should avoid hedging on US equity holdings.

    However, your answer did not fully clarify a point that I think I should properly understand:

    “…in 2008, when markets plummeted around the world but the US dollar rose, Canadians who had USD exposure lost less than they would have without that currency exposure.”

    I understand “Canadians who had USD exposure” to mean Canadians owning equity based in the US, but not Canadian investors holding GLOBAL equities priced in USD. Am I correct in this understanding?

  17. Canadian Couch Potato March 8, 2014 at 6:36 pm #

    @Oldie: Global equities are not priced in USD:
    http://canadiancouchpotato.com/2014/01/16/currency-exposure-in-international-equity-etfs/

  18. Oldie March 8, 2014 at 7:56 pm #

    @CCP: My apologies, I am probably using imprecise terminology which I’ll try to clarify. I was referring to ETFs representing indexes of world markets, but sold in the US in US Dollars, for instance VXUS. You are trying hard to educate us, but owing to many different situations (what currencies the underlying Global equities originate in, what currency the ETF is priced in, and the native currency, CAD in this particular situation, of the ETF purchaser) it is important for us students to keep clear track of which is which.

    To re-package my question:

    I understand “Canadians who had USD exposure” to mean Canadians owning equity based in the US (e.g. VTI), but not Canadian investors holding GLOBAL equities packaged in ETFs sold in USD (e.g.VXUS). Am I correct in this understanding?

    (In your detailed linked article above you said that “your currency exposure comes from the fund’s underlying holdings, not from its trading currency”. I took this to mean that, as a Canadian holding VXUS, despite paying the purchase price in USD, I would not have any USD currency exposure.)

  19. Ben March 8, 2014 at 10:26 pm #

    Hello Dan,

    I have recently opened a TFSA with TD and I am trying to follow your Canadian Couch Potato portfolio with the TD E-series mutual funds. I am only 21 but I am unsure how to diversify my portfolio. You always mention we should rebalance the portfolio, but you don’t mention how. Although I am young, I don’t know if I’ll need my money in 3 years for a house downpayment or in 50 years for retirement, so about the equity to bond ratio I should keep.

    So far I have:
    10% International index
    20% US index
    20% Canadian Index
    30% Canadian Bond Index
    20% Cash + I have more cash to put into my account

    I’m unsure where to allocate the rest of my cash. Would you be able to advise me? So far since I have invested, my bonds have only gone down in price, and my equity has gone up quite a bit.

    Thanks in advance for your time!

  20. Canadian Couch Potato March 8, 2014 at 10:41 pm #

    @Ben: The first thing you need to do is decide whether you’re saving for retirement or for a house purchase in three years. These are completely different objectives. Any money you need within three years should be in cash or a GIC maturing in less than three years: don’t even think about equity or bond index funds for this purpose.
    http://canadiancouchpotato.com/2010/11/10/ready-willing-and-able-to-take-risk/

    Regarding rebalancing, here’s an introduction:
    http://canadiancouchpotato.com/2011/02/22/why-rebalance-your-portfolio/

    Not sure when you bought your bond index fund, but its total return has probably not been negative even if its price has gone down:
    http://canadiancouchpotato.com/2013/06/10/whats-happening-to-my-bond-etf/

  21. Cecilia March 10, 2014 at 3:45 am #

    Hi Dan,

    I built a basic couch potato portfolio a few years back (XSP, XIC, XBB) and I notice the suggested etfs have changed over the years. Do you suggest selling the old etfs and building a new portfolio with the new suggested ones? Thx

  22. Canadian Couch Potato March 10, 2014 at 9:33 am #

    @Cecilia: The old MoneySense Couch Potato portfolios included XSP and XIC because there were no better alternatives at the time. But now there are less expensive ETFs that do not use currency hedging. It may not be necessary to rush out to exchange XIC: the alternatives will just save you 0.10% a year or so, which may not even be worth the two trading commissions it would cost to switch. But XSP is both too expensive and currency hedged, and there are much better alternatives.

    Note also that the old Couch Potato portfolio you have does not include international stocks. The Global Couch Potato on my model portfolios page adds a fourth fund for broader diversification outside Canada and the US.

  23. Andrew March 10, 2014 at 8:12 pm #

    The recent fall in the Canadian dollar has given me cause to consider the big picture of currency hedging against the US dollar for Canadian retirement savers. Many of us intend to spend time during winters in the US. Savings earmarked for costs associated with US travel should clearly not be hedged (snowbird funds). This part is a no brainer.
    Further consideration should be given to the “reserve currency” nature of the US dollar. What this implies is that there is likely to be much greater volatility in the Canadian dollar’s purchasing power when compared to that of the US dollar. In proof of this, in spite of the Federal Reserve’s best efforts to undermine the value of the greenback, at times of unrest investors still flock to the US$. Hedging back to Canadian dollars may actually result in increased risk to lifestyle affordability. The cost of energy, food and many goods is much more stable with respect to the US $ over time.

  24. Roger March 11, 2014 at 10:09 am #

    Hi Dan
    Good article. I was looking at TD e funds and noticed that 5yr,10yr, and since incep. that the hedged version had out performed the unhedged. (US index funds, Cdn dollar version). Would holding and equal amount of both be something to considering to cover the rise and fall of the Canadian dollar over the long hall.
    Thanks Roger

  25. Canadian Couch Potato March 11, 2014 at 11:29 am #

    @Roger: The 10-year performance (ending Feb 2014) for the hedged version of the TD US Index Fund (e-Series) was 5.37% annually. The S&P 500 returned 7.16% in USD over that same period, which means the tracking error of the fund was pretty dreadful. There’s no doubt that hedging will help you over some periods, but only if there is a very strong downward move in the US dollar, and even then it won’t help you as much as it should have, as the performance of this fund reveals.

    Hedging half your foreign currency is a pretty common strategy, even among institutional investors. It is probably the strategy of least regret, but the research I linked above found that a half-hedged portfolio is still more volatile than a fully unhedged one.

  26. Oldie March 11, 2014 at 2:39 pm #

    “Strategy of least regret” Haha — I just love all this terminology arising from Investment Psychology! It really forces you to look at how you think, and maybe confronts difficult questions you’d rather not have to deal with. Like, if you were less “regretful” in 30 years time (because you thought, erroneously, as it turns out, that you’d made less mistakes) but actually had come out with less profit, due to investing ignorance, would you actually be better off?

    I guess those of us who have ditched our active investing advisors who we used to trust so innocently and dearly have come to at least a partial answer.

  27. ccpfan March 12, 2014 at 9:28 am #

    Oldie: Would you regret picking the wrong lottery number and not having won millions? Larry Swedroe says that one shouldn’t confuse strategy and outcome.

    Me, I prefer not having bet my 3$ in the first place.

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