Ask the Spud: Is It Time to Hedge Currency?

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.

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.

 

35 Responses to Ask the Spud: Is It Time to Hedge Currency?

  1. amber tree March 7, 2016 at 10:25 am #

    Being European, I have a similar question: hedge my US position?
    For now, my answer is the same: NO

    No real hard number reasons: I like the diversification it brings and hedging comes at a cost as well.

    As the EUR is quite weak now, and I just bought some US trackers, I actually paid a lot. In a few years, I might want to get out and the EUR could be strong at that time… A concern for that time I would say.

  2. Russ March 7, 2016 at 10:35 am #

    For better or for worse, in my RRSP I have chosen to go 50% unhedged and 50% currency neutral for my US and International TD e-series funds. With the decline in the Canadian dollar that has meant a drag on returns, but since I rebalanced in January the currency neutral positions have outperformed the unhedged versions.

    I have no confidence in my ability to predict which way the equity or currency markets are going to go, so I maintain the 50/50 unhedged/hedged approach and rebalance the whole account (including Canadian Equity and Canadian Bond e-series funds) annually in January as well as anytime the imbalance in a fund exceeds 5% of my target allocation.

  3. Jon March 7, 2016 at 10:36 am #

    For indecisive people, how would a 50/50 split be? I assume we would forfeit any extra gains but also any extra loss, yeah? But it might help them cope with the stress of fluctuation.

    50% hedged
    50% unhedged

  4. Canadian Couch Potato March 7, 2016 at 11:16 am #

    @Russ and Jon: I like to call the 50/50 allocation the “decision of least regret.” Whatever happens, you are not likely to go too far wrong, and I wouldn’t argue with anyone who decided to do stick to that over the long term.

    For the record, though, I should stress that the decision to go completely unhedged is not the same as making a prediction that the Canadian dollar will go down. As described in the blog, the unhedged portfolio is expected to offer more diversification and tighter tracking error regardless of the direction of currency fluctuations.

  5. Kenny March 7, 2016 at 11:37 am #

    What about if you don’t care about volatility, have future expenses in CAD, have a long time-frame, are investing tax-sheltered, and have no plans to switch back (or are just starting)?

    I know I’m really picking my variables here, but it’s also the situation a lot of readers will be in.

    (I also find it interesting that Wealthsimple has moved their default to hedged now)

  6. peter March 7, 2016 at 12:31 pm #

    couldn’t this have been dealt with in a single sentence: “Trying to guess FX markets is basically timing and trying to time any market is a fool’s errand” No?
    nuff said?

    Not that I’m that smart – I thought I had perfectly “timed” the CAD-USD rate (albeit indirectly) last March 2015 when, figuring the CAD just couldn’t drop any further, I rationalized selling a batch of USD denominated securities to raise the down payment on a house.
    well I am still glad we bought the house but I was dead wrong that the CAD had bottomed out.

  7. Paul G. March 7, 2016 at 1:18 pm #

    Thanks for an interesting post.
    I think the question of when to switch back is the key issue. Moreso since large currency shifts usually happen in times of general instability, when no one wants to make a large decision and commit to it.

  8. Steve March 7, 2016 at 1:26 pm #

    Great article, thanks a lot! All of my ETF holdings are unhedged and it’s good to get a reminder once in a while why this is the best strategy.
    Steve

  9. TM March 7, 2016 at 2:58 pm #

    Thank you so much, CCP.

    I’ve long wondered whether a reasonable hedging strategy might be to hold the same or similar equities in US and Canadian funds. For example, getting half of my US exposure from VTI (US funds) and the other half of US exposure from VUN (CAD). Similarly, investing half in XEF and half in VEA for international exposure. It seems that investors like myself who already have both US and Canadian dollar investments, this would be a way to hedge against currency fluctuation. I imagine this might make rebalancing more tricky, but it would cancel out CAD/USD fluctuation, would it not? Thanks so much for all your insights.

  10. Canadian Couch Potato March 7, 2016 at 3:53 pm #

    @TM: Because VUN is unhedged, it actually has the exact same currency exposure as VTI. This is a common misunderstanding:
    http://canadiancouchpotato.com/2014/01/13/how-a-falling-loonie-affects-us-equity-etfs/
    http://canadiancouchpotato.com/2014/01/16/currency-exposure-in-international-equity-etfs/

  11. Patrick March 7, 2016 at 8:54 pm #

    Well, if one must hedge, instead of converting back and forth between hedged and unhedged etfs, possibly over decades, which would generate gains/losses on currency exchange and appreciation/loss in the US index, why not just short the US dollar? This could be accomplished by shorting DLR.

    This way, it’s hard to pretend that hedging is not a currency bet on the side. You can also hedge any fraction of your position, say 50% by simply hedging 50% of the USD exposure.

  12. Retail Investor March 8, 2016 at 11:11 am #

    (1) Beats me why passive investors always claim that not-hedging is the passive choice ‘ because you don’t know where the FX will go’. Just because ‘action’ must be taken to reduce your FX exposure does not make it ‘active investing’. I argue that hedging and staying hedged is the passive choice for the same reason. I don’t know where FX rates will go. I do not want to play the FX game. I do not want FX gains or losses.

    (2) It is only those people who rotate between hedging when the Loonie rises, and non-hedging when the Loonie falls that are the ‘active’ investors who need to time the market. Presumably they feel they CAN indeed predict the swings. Disputing this choice is not an argument against ‘hedging and staying hedged’.

    (3) There is no ‘cost’ to hedging. When I DIY it is essentially free. The ETFs have figured out how to do it. Their last 5 years have tracked without a hitch. http://bigcharts.marketwatch.com/advchart/frames/frames.asp?show=&insttype=Fund&symb=ca%3Axsp&time=12&startdate=1%2F4%2F1999&enddate=6%2F6%2F2013&freq=1&compidx=SP500&comptemptext=&comp=none&ma=0&maval=9&uf=0&lf=4&lf2=0&lf3=4194304&type=2&style=320&size=2&x=43&y=12&timeFrameToggle=false&compareToToggle=false&indicatorsToggle=false&chartStyleToggle=false&state=14

    (4) Hedging does not reduce volatility. Only one year in history, has hedging increased a loss for a Canadian. The difference in return volatility is immaterial to anyone. See Sheet 35 at http://www.retailinvestor.org/StatsCan.xls

    (5) A diverse world-wide portfolio will not protect you from currency swings. Currencies do not mean revert. And there have not been any currencies Canadians would have owned by default (for their stocks) that would have offset the effects of the USD/Loonie FX. See the top two graphs at http://www.retailinvestor.org/hedge.html

    (6) FX swings can/do extend for mutliple decades. The typical investment horizon of an individual is much shorter. There is no way any individual should accept the risk of be left with the short straw.

  13. AR March 8, 2016 at 2:30 pm #

    I should also add that the trigger that would send the loonie upwards – rising oil prices – should also boost the TSX, including but not limited to energy stocks. Over the last year, I’ve been observing their movements and it appears that energy stock prices are 3-4x more volatile than the loonie. So, if you have any significant stock holdings in the TSX, that should more than compensate for a rising loonie. JMO.

  14. oldie March 8, 2016 at 6:57 pm #

    Another wonderful CCP aphorism to remember, in that last paragraph…

    “The insight comes when you realize there’s no but.”

    Haha, that fear-filled reptile brain of ours is hard to ignore, so we need as many guidelines to rationality as we can get!

  15. oldie March 9, 2016 at 5:38 pm #

    @CCP:

    In the “A currency-hedged portfolio is more volatile” paragraph, you said “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.”

    Please elaborate: the smaller losses have nothing to do with the fact that the global non-US ETF stocks may be at least partially built through owning intermediate shares of USD based ETFs, right? (because the USD is only the intermediary currency between the foreign currency and the Loonie.) So I think you must mean that the off-shore losses are counterbalanced by the USD-CAD currency exchange “free-gift, which would deliver an equity appreciation gain in CAD even in the face of a minor depreciation when measured in USD.

    If this is what you mean, then it would require that you always had a decent exposure in US Equity in your asset allocation for this to work, say 50/50 split in your non-Canadian Equity. Would this still be the case for the investor closer to his investment horizon who has decreased the total equity proportion? (I guess what I’m asking is whether the Equity portion, no matter how small it is, should still be divided more or less 1/3 :1/3: 1/3).

  16. oldie March 9, 2016 at 6:16 pm #

    Another plausible interpretation (which I discount, as reasoned out later) to your statement might be to have offsetting currency exchange benefits through owning global equity ETFs priced in USD bought on the US stock market. But this won’t work, would it, for basically the same reason as the first part of my second paragraph, above, right?

  17. jamie March 9, 2016 at 6:56 pm #

    great discussion as usual!
    CP, would you weigh in on ‘Retail Investor’ above. He is raising some interesting points like: if hedging doesn’t drag the index, is the passive approach to hedge or not to hedge?
    As always, thanks.

  18. AR March 9, 2016 at 7:27 pm #

    Oldie,

    The intermediary currency plays no role. If I purchased the ETF NORW, which is an unhedged ETF of Norwegian stocks, listed on the NYSE and priced in USD its underlying exposure is only in Norwegian Krone. If oil prices rise like crazy, the Krone will certainly appreciate against the USD. The Krone will also appreciate a bit against the CAD, but less so (because the CAD is also a petrocurrency, but less intensely so than the Krone). Therefore, the value of the ETF will rise like crazy in USD, and rise a moderate amount in CAD.

  19. oldie March 9, 2016 at 9:12 pm #

    @AR: Yeah, that’s what I figured out, slowly, in small steps, but eventually correctly, lol.

  20. Canadian Couch Potato March 10, 2016 at 8:25 am #

    @jamie: It’s important to separate the theory from the practice here. If hedging were precise and free, then one could make a good argument for choosing either one (or a 50/50 approach). But in practice we know that hedged ETFs frequently have large tracking errors. And while their MERs are not usually higher, hedged ETFs are often less tax-efficient. First, in a taxable account they tend to have more capital gains distributions, which can result from rolling over the forward contracts every month. Second, if you hold your foreign equities in an RRSP you can use US-listed ETFs (always non-hedged) to significantly reduce foreign withholding taxes. So in these examples, even assuming perfect tracking error and identical MERs, the non-hedged approach is likely to be better.

    But let’s not lose sight of the main argument of the post: the problem is not that currency hedging is a terrible strategy. If you use hedging (either fully or half and half) with long-term discipline, I’m not going to argue too strenuously. The point is that many investors are now talking about switching back and forth depending on the current exchange rate. It’s this undisciplined behaviour that erodes returns.

  21. Steve March 10, 2016 at 12:39 pm #

    I’m paid in US$ and I’m currently exchanging the entire amount then investing in e-series funds. Would I be better off investing in TDB952 – TD U.S. Index Fund (US$) leaving it in USD instead of exchanging and investing in TDB902 – TD U.S. Index Fund (CA$)?

  22. Canadian Couch Potato March 10, 2016 at 12:49 pm #

    @Steve: In general, yes, if you have USD cash and you plan to buy unhedged US or international equities then it makes god sense to use USD-denominated funds, whether that is TDB982 or a US-listed ETF.

  23. Yong Compston March 11, 2016 at 6:36 pm #

    However, like all asset classes, real-return bonds are exposed to several risks, and investors need to understand these so they’re not surprised when the asset class performs poorly, as it has in the past year or so.

  24. Shaun March 18, 2016 at 4:02 pm #

    @CPP
    Thanks for the hat tip

    @ Retail Investor
    I was interested by you post and specifically the “bigcharts” link. I had looked at the same thing here but with a different story:
    http://stockcharts.com/freecharts/perf.php?xsp.to,ivv

    According to stockchart.com XSP has under-performed the underlying IVV by about 3% cumulative over the past 5 years. This is confirmed if you have a look at the iShares sites directly here:
    https://www.blackrock.com/ca/individual/en/products/239727/ishares-sp-500-index-etf-cadhedged-fund
    https://www.ishares.com/us/products/239726/ishares-core-sp-500-etf

    iShares shows 5 yr cumulative returns ending Feb 29, 2106 as 58.57% for XSP and 61.52% for IVV. This equates to about a 3% drag over the past 5 years. This is far cheaper than it was in the previous 5 year period, but it is inaccurate to call it “no cost” as you did in your post your post.

    Your statement “Only one year in history, has hedging increased a loss for a Canadian” is totally false. Looking at the stats can data you linked, it clearly shows that a non-hedged strategy would have been advantageous the majority of the years when a Canadian would have experienced a loss with a 1/3 1/3 1/3 portfolio all hedged. You don’t have to go back very far. How about last year where an hedged portfolio showed -3% and unhedged was +10%. Since 2000 the following years with a loss if all hedged would have been minimized if they were all un-hedged: 2015, 2011, 2008, 2001, 2000. In fact since 2000 the only year with a loss where hedge was better than un-hedged was in 2002 and it was basically a wash.

    I have read many academic papers about hedging and at all but yours state that that for commodity based currencies like Canada, an un-hedged portfolio will provide less volatility, as long as the foreign equities do not make up a very high percentage of the entire portfolio.

    I read your post about hedging. I think it is fair to say that the majority of the strategies you are talking about for executing a hedge are beyond the reach of a DIY investor. The only realistic option we have is the use of hedged ETFs. As I showed above, and CCP has many time before, these do have a cost and will drag long term returns.

  25. Frank March 24, 2016 at 5:07 pm #

    @ Shaun
    I am trying to understand why there is a negative correlation between international equities and the Canadian Dollar. Do any of the academic papers you mention explain this? Could you provide a link? Thank you very much.

  26. Shaun April 25, 2016 at 4:53 pm #

    @ Frank
    That is a tricky one, depending on exactly what you are asking. There is a negative correlation between the Canadian Dollar and foreign equities measured in Canadian dollars for hopefully obvious reasons. To spell it out if the Canadian dollar relative to the USD drops 10% it means that the USD goes up 10% so any un-hedged foreign equities would go up 10% when measured in Canadian Dollars due to the currency.

    But I think what you were asking was more along the lines of: why does the Canadian Dollar trend to drop when global stock markets drop (positive correlation). This is a more complicated one but from what I have read (sorry no time to go find links) there are two main contributors:

    1) When world markets tumble money tends to flow to the safety of the USD which makes the Canadian Dollar relatively weak

    2) When the world economy goes into a recession, there is often less demand for commodities like oil and precious metals because there are fewer projects being done. When commodity prices drop, the currencies of countries who produce those commodities tend to go along for the ride. They are often referred to as petro-currencies. Canada is one of those countries. So when demand for commodities we produce decreases, which often happens in a recession, then the Canadian dollar tends to fall and un-hedged foreign equities tend to go up.

    Hope that helps.

  27. Mike April 27, 2016 at 12:57 pm #

    I’m currently invested in TDB905 (Currency Neutral), and after reading articles like this I am considering the un-hedged version, TDB911. Are there any drawbacks to making that switch immediately, or holding off until the Canadian dollar moves closer to the US? (whenever that might be…)

  28. Canadian Couch Potato April 27, 2016 at 4:06 pm #

    @Mike: The drawback is simply that you could end up being “wrong”: if the CAD continues to appreciate, the original currency neutral fund would outperform. So you need to be prepared for that. Over the very long term, it makes sense to pick one or the other and avoid switching back and forth.

  29. Lance May 8, 2016 at 1:56 pm #

    Perhaps it can be done once.

    I hold RBC index funds in my TFSA and e-series in my daughters RESP.

    I am thinking of adding a small cap ETF to my personal TFSA; in order to increase long term returns.

    If the CAD reaches parity, purchasing the unhedged IWM (Russell 2000 ETF), could have upside as we would certainly expect the CAD to drop once again.

    When the CAD does drop, I would sell IWM and replace it with the the hedged version XSU.

    While I wouldn’t be able to exactly time
    the top or bottom, surely the benefits of switching to the hedged version outweigh the negative impacts of inexactly timing the top or bottom.

  30. Jason May 19, 2016 at 3:22 pm #

    @ Canadian Couch Potato April 27, 2016 at 4:06 pm #

    I think we are done with the CAD appreciation for a while, and we are heading back to 70c and maybe below. I kind of liked it when our dollar reached 80c a few weeks ago – it was a good middle ground, however I had no illusions it would stabilize there.

  31. JEFF WHITE June 19, 2016 at 11:14 am #

    Could CCP please explain how hedging basically works ?
    I’m new here
    Thanks
    Jeff

  32. Diggle July 13, 2016 at 10:23 pm #

    People like to say hedged funds cost more; with Vanguard, the MERs are generally the same between hedged and unhedged funds.

    My question is : are there hidden fees in hedged funds to actually do the “hedging”?

  33. Canadian Couch Potato July 14, 2016 at 8:34 am #

    @Diggle: Hedged ETFs are not more meaningfully expensive: the fees associated with the hedging strategy are very low. The issue is that they tend to do a poorer job at tracking their indexes, and they can also be tax-inefficient.

  34. Remi August 9, 2016 at 9:19 pm #

    Hi,

    Noob question here:

    Is the “exchange risk” the same between buying ETFs with $USD (in a USD account) VS buying ETFs that contain US stocks with $CAD (in a CAD account) ?

    I know you believe hedging generally is a good idea, but to help me understand, which of those 2 options would you hedge first?

    Thanks!

    Remi

  35. Canadian Couch Potato August 10, 2016 at 8:37 am #

    @Remi: Actually I do not generally recommend hedging currency.

    To address your question, assuming you use an ETF without hedging, the currency risk is the same whether you use a USD-denominated ETF or a CAD-denominated ETF whose underlying holdings are US stocks. This should help:
    http://canadiancouchpotato.com/2014/01/13/how-a-falling-loonie-affects-us-equity-etfs/

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