We’re not quite in “northern peso” territory yet, but the Canadian dollar has taken a beating over the last couple of months. And any time there is a significant move in the markets—whether it’s stocks, interest rates or currencies—investors second-guess themselves. Of course, the financial media is always there to support them with hyperbole, overreactions and short-term thinking.

Investors might now be wondering if they should reposition their portfolios in light of the dollar’s weakness, and the subject of currency hedging inevitably arises. Let’s start with a refresher on how this strategy works.

When you hold US or international equities, you are also exposed to foreign currencies. The exchange rate between the Canadian dollar and these other currencies will affect your returns. Index funds that use currency hedging (these typically have “CAD Hedged” or “Currency Neutral” in their name) attempt to eliminate the effect of exchange rates and deliver the returns of foreign equities in their local currencies. For example, if the S&P 500 returns 10% for US investors, a currency-hedged S&P 500 should also deliver 10% in Canadian-dollar terms, regardless of whether the loonie rose or fell during the period.

A falling loonie is good for your foreign equities

I’ve received questions from investors who are worried the Canadian dollar will fall further and are wondering if they should switch to currency hedged funds for their US and international equities. But this is getting it exactly backwards. Currency hedging protects Canadian investors from a rising loonie, not a falling one.

This is actually quite intuitive. When we speak of the Canadian dollar “falling,” this implies an increase in the value of foreign currencies by comparison. So if you are exposed to US and international currencies in your portfolio, you will benefit from that increase. The worst time to use currency hedging is when the loonie is plummeting.

Now, if you believe the Canadian dollar has neared its bottom and will begin moving back up, then it makes theoretical sense to use currency hedging, because a rising loonie would harm returns. For Canadians who held unhedged foreign equities, the worst period in recent times was 2002 through 2007, when the Canadian dollar soared from about $0.63 to over $1.02 USD. During those six years, the S&P 500 returned over 6% annually in US dollars, but lost about 2% a year in Canadian-dollar terms.

Why hedging disappoints

I stressed the word theoretical for a reason. Currency-hedged index funds have a long history of high tracking error, which means they may not offer the protection investors expect. One reason is the cost involved in maintaining the forward contracts, although this is relatively small. The biggest factor is the volatility of currencies. Funds reset their currency hedges once a month, but big moves in the exchange rate frequently occur during the intervals. For that reason, hedging is not very precise. As Rob Carrick once described it: “Hedging is like playing hockey with a baseball bat. It can be done, but the results are clumsy.”

All of which means a currency-hedged ETF may not even protect you during a period of strong appreciation in the loonie. As Justin Bender found when he looked at the currency-hedged iShares Core S&P 500 (XSP), the strategy delivered no benefit at all from 2006 through 2011, even though the Canadian dollar rose more than 14% from about $0.86 to almost $0.99 during that period.

That’s why it’s not correct to say that the hedged-versus-unhedged decision should even out over the long term. Currency fluctuations might even out over the very long term, but unhedged funds will almost certainly track their benchmarks more precisely. Therefore, during periods when the Canadian dollar falls in value, you get the full benefit with an unhedged foreign equity ETF. But during periods when the loonie rises, the benefit of hedging may be muted, or even nonexistent.

It would be ideal if we could turn currency hedging on and off at the right times. But in the absence of this magical power, a better strategy is to keep your foreign equities unhedged and simply use a rebalancing strategy to smooth out the ride.