In my last post I argued that Canadians should avoid currency hedging in their equity portfolios. Not only does exposure to the US dollar and other foreign currencies add a layer of diversification, but hedging strategies can be imprecise and ineffective. I ended that article by encouraging investors to simply “use a rebalancing strategy to smooth out the ride.” Let’s explore that idea a little more.
The first point to understand before we go further is that you should measure your investment returns in Canadian dollars, even if some of your assets are denominated in other currencies. Indeed, you’re probably already doing that, especially if you hold US and international equities through mutual funds or Canadian-listed ETFs. The net asset value of these funds is always given in Canadian dollars, and any fluctuations in foreign exchange rates is already factored in. Even if you use US-listed ETFs, most online brokerages display the market value of your holdings in Canadian dollars, but if you’re looking at the funds’ US websites or getting quotes on Google Finance, you may be misled by returns given in US dollars.
The second key idea is that when you own foreign equities, you actually own two assets: the stocks themselves, and the currency in which they are denominated. These exposures will affect your returns—as measured in Canadian dollars—more or less independently. And therefore you need to consider both when managing and rebalancing your portfolio.
Back to balance
Say an investor we’ll call Conway has a $50,000 portfolio with a target mix of half Canadian and half US equities. Conway uses a US-listed ETF for his American holdings. If we assume the loonie and the US dollar are at par when he implements his portfolio, his holdings start off like this:
| Value in CAD | Value in USD | % | |
|---|---|---|---|
| Canadian equity | $25,000 | 50% | |
| US equity | $25,000 | $25,000 | 50% |
| $50,000 |
Now fast-forward a year and assume (albeit unrealistically) that both Canadian and US stocks have not changed in value in their local currencies, but the Canadian dollar has depreciated sharply and is now worth $0.80 USD. Conway’s portfolio now looks like this:
| Value in CAD | Value in USD | % | |
|---|---|---|---|
| Canadian equity | $25,000 | 44% | |
| US equity | $31,250 | $25,000 | 56% |
| $50,000 |
Notice that the value of the US holdings is unchanged in USD terms, but Conway measures his returns in Canadian dollars, and the soaring greenback means he’s enjoyed a significant bump in the value of his US equity holdings. In fact, the portfolio is now well off its target and it’s time to rebalance.
Since the portfolio is now valued at $56,250, Conway should hold half that amount ($28,125) in each of his two asset classes. So he simply sells $3,125 CAD worth of his US holdings and adds that money to his Canadian equity holdings. With the loonie at $0.80 USD, he needs to sell $2,250 USD worth of his ETF in order to collect $3,125 CAD in proceeds. When these transactions are complete, Conway’s portfolio is back to balance:
| Value in CAD | Value in USD | % | |
|---|---|---|---|
| Canadian equity | $28,125 | 50% | |
| US equity | $28,125 | $22,500 | 50% |
| $50,000 |
In this example, the stocks themselves have not changed in value, but their currency has appreciated by 25%. If the US-Canadian exchange rate had remained unchanged but the stocks had increased by 25%, the effect would have been the same. Conway should therefore take the same action in both cases: rebalance back to his target asset mix in Canadian-dollar terms.
Stick to the math
It’s easy to make this decision more complicated than it needs to be. Investors wonder aloud whether the US dollar is “overvalued.” Wouldn’t it make sense to switch to a currency-hedged strategy to protect yourself from its “inevitable” correction? Does an 80-cent loonie change the game fundamentally, and is it time to think about reducing the exposure to US dollars in your long-term asset mix?
These ideas sound sensible, but the problem is always the same: no one can predict the movements of exchange rates, any more than they can forecast stock markets or interest rates. It’s hard to understand how any investor can fail to appreciate that after the last five years or so. This unpredictability is precisely why we build balanced portfolios with multiple risk factors—including currency exposure—and hold those assets all the time.
You can make a bet on one possible outcome and hope you get lucky. Or you can diversify broadly, rebalance regularly and take comfort in the fact that being half right is better than being dead wrong.
Such a timely article! I just sold some US equities to rebalance. How do I get the US$ to my Canadian account?
Great Post.
I agree that it is easy to make the decision more compicated than it is but consider the following.
To do the transactions in the post using Norbert’s gambit would require four commission be paid.
1) Sell the US listed ETF
2) Buy DLR.u
3) Sell DLR
4) Buy the Canadian ETF
Given the transaction size is only $3,125 CAD the four transaction represent more than 1% of the amount invested (assuming a $9.99 commission on each trade). Should an investor wait for perhaps a larger spread before rebalancing in this way?
@Linda: Norbert’s gambit if the amount is large enough (see below).
@Tennis Lover: You’re right, $3,125 is too small an amount to make Norbert’s gambit worthwhile. This was a simplified example: in reality it rarely makes sense to use US-listed ETFs for small portfolios like this for that reason. Whatever you save in MER and withholding taxes can get eaten up by higher transactions costs at rebalancing time.
I don’t know about other brokers, but qtrade lists dollar amounts in the currency of the account. If you have US ETFs in a US account, the values are shown in $US.
Norbert’s Gambit works fine if your converting from Cdn $ to USD, but for the reverse (if you’re required to hold for 3 days while DLR.u settles, and I know Scotia iTrade requires this) then you are subject to ER variations. If instead you bought an interlisted stock on the US exchange you could journal the shares over to your Canadian margin account (again after the 3 day settlement period). This would only require 2 commissions. Of course you want to use a stock with a relatively stable price. Both methods have ER risk, but the interlisted stock also has share price risk. The tradeoff is less cost in commissions.
Could you please show us the affect of this exchange rate fluctuation if the investor bought the US Equities @ TSX in CAD. Everything else remain same, I would like to see how the ETF Price moves when the conversion has gone from at PAR to $USD 0.80. I do buy US Equities only at TSX thru ETF, like, VUN.
regards
Ehsan
Watch out if you rebalance in a taxable account. The way share prices have appreciated in the US, selling US equity (ETFs) is likely to incur significant taxes because of the associated capital gains.
While the point of the article is very valid, if you keep on adding cash to your portfolio, it might make more sense to rebalance by adding to other asset classes instead of actually selling from the US equity position.
@Holger: I tried to do the rebalance by adding to the other assets thing. Because of the amazing rise of the US$ and VTI, I’d need to add far more $$$ than I could. If I want to rebalance, I have to sell, and I have to see in my un-sheltered account.
@CCP: I’m going to be hit by a large cap gain if I sell to rebalance. I’ve been told to never make investing decisions based upon tax consequences, but I’m really having to think about this one. At what point does it make sense to take the hit? Or should I live with the unbalance and add whatever funds I can while waiting for the US$ & VTI to drop again relative to everything else?
If my strategy is 1/3 CAD, 1/3 US and 1/3 INTL ETFs, is it OK to have 2/3 of my holdings in US$?
@Ehsan: If you hold your US equities via a Canadian-listed ETF the effect is the same (assuming the ETF is unhedged). In the example above, the investor’s US equity fund would still rise from $25,000 to $31,250. Using Canadian ETFs actually makes things easier, because you won’t be distracted by the USD value on your brokerage statement, and because can rebalance with no currency conversion.
@Chris/Holger: I understand that reflectance to avoid capital gains taxes, but risk management should come first. Remember that rebalancing frequently involves selling assets that have gone up in value, so crystallizing gains is probably inevitable at some point.
@John Rock: You would actually have only 1/3 of your holding in USD. If you use a US-listed ETF to hold international equities you are not exposed to the US dollar. This is a common misunderstanding:
https://canadiancouchpotato.com/2014/01/16/currency-exposure-in-international-equity-etfs/
@CCP: A timely and informative review on a question that I have recently puzzled over a lot, in the wake of the rapidly declining loonie. As you point out, intuitive reasoning indeed suggests that the imbalance is merely an illusionary distortion caused by the “undervalued” loonie. But careful application of the Couch Potato principle that you cannot predict the future leads to the conclusion that historical and recent trends in FX are useless in predicting either where on the FX scale the loonie will end up, or when.
It’s reassuring to see the that the official CP conclusion matches with my own; but it’s also gratifying to find that, once again, basic CP education provides the necessary tools for avoiding emotive bias and safely reasoning your way through a lot of confusing issues. Thanks!
@CPP : I currently have CAD $50,000 in a RRSP and would like to invest that in a US traded ETF in USD, however since the Canadian dollar is at the low end I would currently get less than 40,000 USD a massive 10,000 less
I see already my stomach churn if the C$ appreciates… but would like to think beyond that…please give an example or article explaining the same.. as I have only seen examples on this and various sites where we started at par with the U$ and then the C$ drops… so it always looks good or safe even if the underlying instruments went -ve or not.
Please explain the whole diversification across currencies as I would like to think beyond an exchange rate (esp. now) and be invested in multiple markets and understand those benefits.
Looking forward to your reply..
Thanks
Ivan
@Ivan: If you search this blog for “diversification” (find the search box at the top of this page on the right under the masthead, type in “diversification”, and hit “enter”) you will be directed to several excellent posts that Dan has written in recent years that pertain to your concern, as well as to the latest (2015) basic model portfolios, that would seem to be ideally designed for someone requesting the information that you seek.
(I am assuming that you don’t have any particular reason for investing the whole CAD$50,000 in US traded ETFs except for not seeing the benefits of diversification, yet).
Great post, as always. As an American living in Canada, I have most of my investments in US listed ETFs due to the onerous US reporting requirements for citizens living abroad, so this is very useful information for me.
One other question I have is regarding mortgage terms in Canada. In the US, it’s more common to have your mortgage terms equal the amortization of your loan, so your loan terms will be the same for the whole 30 years of the loan. Here of course, the terms are much shorter, and my mortgage is up for renewal. The rates are much lower for a 2 year term as opposed to say a 7 year term. From a couch potato standpoint, is there any reason to not take the 2 year term? If you expect interest rates to rise, a longer term would make sense, but if you take the position that it’s impossible to predict future interest rates, it seems like it would make sense to do the shorter term with the lower interest rate. I would appreciate your input, and maybe you could use this as a possible topic in one of your posts. Thanks so much.
I think it’s pretty well established that shorter-term mortgages offer better rates (even better are the variable-rate mortgages) and are as a general rule a better deal, the only caveat being that you have to be able to withstand the volatility, including much higher rates for a “short” period (1-3 years).
Sorry off topic
What would be a benefit of the new XSI etf with the much MER higher than say VSB or XSB with much lower MER ?
@EH and Paul G: I would treat this decision in a similar way to the decision between short and longer-term bonds. It’s not about guessing where you think interest rates are headed. It’s more about your tolerance for volatility. If you are comfortable with the risk the rate could go up by the take you renew, then take the shorter term. If you value the predictability and stability of a longer term and you;re willing to pay a little extra for that, then take the longer term.
@Jake: XSI is an actively managed fund full of floating rate notes and high-yield bonds. It has a completely different risk profile compared with VSB or XSB, which is all short-term investment grade bonds.
I exchanged large sum of fund from CAD to USD at 1.10 in 2014 and bought US stocks only.
I’m experiencing a large capital gains return due to the depreciation of the CAD dollar. I was thinking of selling all my US stocks, paying off my debt, and investing in “ZUE: BMO S&P 500 Hedged to CAD Index ETF” since the CAD is down.
What do you think ?
@Sam: That’s pretty much going for market timing, which is against the whole Couch Potato philosophy. I can understand the temptation, though, but it’s still an active bet.
Good Evening,
I based my portfolio on the previous CCP model, and thus own VTI. My problem is that even though my VTI position is 10% out of whack, the amount I’d have to sell in order to rebalance is still too small to justify Norbert’s gambit. Same problem when I need to buy.
There are 2 strategies I can think of:
1) sell all my VTI shares and switch to VUN
2) sell only, say, $10k of VTI, buy VUN, and use VUN for rebalancing purposes. When VUN reaches $20k, I sell half of it to buy VTI.
Is strategy #2 too complex? Is it worth it?
Or is strategy #1 better because the Canadian dollar has lost so much value that now is a good time to switch to a $CAN ETF?
Thanks,
Sophia
@Sophia: You’ve hit one one of the reasons why removed US-listed ETFs from my model portfolios. If you are investing in a TFSA or non-registered account it would make sense to just switch to VUN. In an RRSP the decision depends on how much complexity you are comfortable with. Strategy #2 is probably cheaper, but it makes things a little more comp0licated, as you’ve anticipated.
Note that the current USD/CAD exchange rate is always irrelevant to the decision:
https://canadiancouchpotato.com/2014/01/13/how-a-falling-loonie-affects-us-equity-etfs/
I hold VTI and VXUS, both trade in USD. For the rebalancing porpuse, I also hold BIV.
Switch to VXC is not an option, since big capital gain.
Dan, how do you think about this USD bond for rebalancing idea? I know you do not recommend holding USD bond.
Forgot to mention that the BIV holding is just 10% of my fixed assets.
Thx
Are the TD Eseries US (TDB 902) and International (TDB 911) index funds traded in US$ and so should be weighted as such?
@Matt: The e-Series funds in my model portfolios are traded in Canadian dollars, though there is a USD version of the US equity fund (TDB952):
https://canadiancouchpotato.com/2010/08/11/will-the-real-sp-500-please-stand-up/
Okay so no conversion calculation needed, thanks :)
Would there be a benefit to replacing the TDB 902 with the TDB 952 as a Canadian since it would diversify our currency holdings?
@Matt: The currency exposure is exactly the same in TDB902 and TDB952:
https://canadiancouchpotato.com/2014/01/13/how-a-falling-loonie-affects-us-equity-etfs/
@Dan. Curious, is there any US based ETF that invest in the Canadian market so that I can buy them to rebalance without doing a gambit?
@Francois: iShares has one: EWC. But you can also purchase HXT in a USD-denominated version:
http://www.horizonsetfs.com/pub/en/etfs/?etf=HXT.U&tab=overview
HXT.U is much cheaper and you would avoid foreign withholding taxes on the dividends. (Remember, dividends paid from a US-listed ETF are not considered Canadian-source dividends.)
“being half right is better than being dead wrong”
That’s probably the best investing tip I’ve read in a long time.
Hi there,
I currently hold VTI and VXUS TO COVER MY U.S. and international holdings. What is your opinion of selling these and buying XAW in place of these two holdings? Thanks for the response!
Mark
@Mark: Canadian-listed ETFs are certainly easier and cheaper to trade because you can avoid currency conversion. But if you already own VTI and VXUS I am not sure I would be in a hurry to sell these, as it would mean converting USD back to CAD.
https://canadiancouchpotato.com/2013/12/09/ask-the-spud-when-should-i-use-us-listed-etfs/
I am just starting a RESP with td e series using a couch potato model portfolio.
My husband insists I don’t buy the U.S. index right now because the loonie is so low. Can you please point me to an article addressing this issue? Thank you
@JC: It’s true that the buying US stocks is more expensive when the loonie is low relative to the US dollar. But the decision to avoid the asset class altogether is just market timing. Until someone finds a way to reliably forecast the future movements of currencies and stock prices, the more prudent strategy is to diversify across many asset classes and rebalance as necessary.
Thank you !
I know that it’s impossible to predict currencies and you recommend not to buy currency hedged ETFs for the long run but theoretically, would a hedged US ETF do better on a rising Loonie in the short run?
@Peter: Yes, a hedged ETF would be expect to outperform during any period when the loonie appreciates versus the US dollar.
What about TD e-series currency neutral us index?
If you were starting a new portfolio with the current exchange rate, would it be best to buy the currency neutral us index?
@Bub: I don’t recommend currency hedged funds, period. While it’s true that the loonie is unusually low right now, it’s dangerous to start thinking you can time these things. If you buy the currency neutral fund now, when do you switch to the unhedged version? And then when do you switch back?
I am new to investing and have a lot to learn so this May be a silly question but would buying the U.S. index right now, with the loonie so low, essentially “buying high”? I understand the loonie can go up OR down but it seems to be like you said, unusually low.
@Bub: Buying a US index fund is not just buying the currency, it’s also buying the stocks. So it’s quite possible for the US dollar to fall while the fund still delivers strong gains. But more important, trying to pick an entry point into any market leaves you vulnerable to big opportunity costs of you’re wrong. Look at the dates on these blog posts: people who sat on the sidelines because they were sure US stocks or bonds over the last couple of years have been punished, even though their arguments seemed obvious at the time:
https://canadiancouchpotato.com/2013/05/28/ask-the-spud-should-i-buy-in-now/
https://canadiancouchpotato.com/2011/07/04/will-rising-rates-really-clobber-bonds/
Thank you! That makes sense.
I decided to read MoneySense Guide to the Perfect Portfolio and most of my questions were answered. Great book for a new diy investor like me.
Hello,
I own VTI in my LIRA and VXC in my rrsp, and these 2 parts of my portfolio have outperformed by TFSA and unregistered accounts. I was under the impression that if you only rebalance with cashflow you dont really crystallize the gains.
Since I cannot move funds out of the LIRA, and fiddling with the RRSP involves a tax event, would having an identical bond fund(that i already have in a TFSA) inside an RRSP make sense? This way I would be able to maintain the 60/40 ratio without affecting RRSP contribution limits or paying unnecessary taxes. Am i thinking about this correctly?
As for the gains in my rsp accounts, the LIRA specifically:
would selling some VTI and buying a bond fund traded in USD trigger a tax event? I want to crystallize the gains and balance my equities/safe stuff ratio but if the taxes and fees exceed the gains it seems useless.
Any thoughts? Thanks.
@Art: I’m not sure I understand your situation here, but certainly no one should ever take money out of an RRSP to rebalance. As you suggest, it often makes sense to keep both bonds and equities in your RRSP so you have some flexibility for rebalancing.
No taxable event arises from selling funds in an RRSP or LIRA.
A disproportionate amount of gains in my portfolio happened in my rrsp and lira. I thought selling some shares inside the account would trigger a tax event and was confused how to rebalance back to 60/40.
Would it make sense to use usd dividends in my lira to also buy bond funds? Or just get a drip going and treat lira as a more passive component of the portfolio?
Thank you for the answer.
@Art: It’s hard to say anything specific without knowing the details of your portfolio. In general, if you can keep just one asset class in your LIRA that’s the easiest solution, but it might not be possible or practical.
One idea that does not come naturally to many investors is that sometimes rebalancing involves selling an asset class in on one account and then buying it back in another:
https://canadiancouchpotato.com/2013/10/30/making-smarter-asset-location-decisions/
I’m an American in Canada. I might live in the US again one day and I might remain in Canada. I have no crystal ball. I also am struggling on how to invest given my current and future residency. I have a small RRSP and a maxed TFSA. Because of my new-found fears for filing incorrectly with the IRS, I have been moving all of my canadian earnings down to a us bank and investing in Betterment. I take the exchange rate hit when I transfer my money down. I can’t use a Roth down there and I can’t use the TFSA here. We really get none of the tax advantages that the usual citizens in either country get. I’m very frustrated. I don’t know if this is how I should be doing it either.
My RRSP is about 15K 2/3rd Cdn dividen acct and 1/3rd US dividen acct. The TFSA is all in high interest savings (no investments).
@Loren: It would be worth consulting a financial planner with cross-border expertise. There are many people in your situation, and some advisors have developed a specialty in this area, for example:
http://cardinalpointwealth.com
I am a dual US Canada citizen. Want to get some recommendations on what to invest in, for my taxable account. Preferred asset allocation is 80/20.
I am considering 2 options:
1) VGRO (simple all in one, great choice for a new investor like myself, no rebalancing needed but considered a PFIC thus yearly accounting fee is present ranging from $700 to $1750 annually for the next 20-25 yrs)
2) holding US ETFs along with some canadian ETFs e.g. VTI + VXUS + VCN + ZDB for diversification. Latter 2 are canadian ETFs but don’t hold any more underlying ETFs thus accounting fee much lower ~ $200-$500 annually for both combined. VTI has excellent returns but current exchange rate is terrible for converting CAD to USD so money could be lost in currency conversion…moreover rebalancing needed which is not my forte yet….
Any suggestions?
Much Thanks guys!