Diversifying your portfolio to gain exposure to securities trading outside Canadian markets is an excellent way to mitigate your losses in case the Canadian economy goes through a broad pullback through the relative stability of foreign securities.
Sometimes, betting beyond the domestic market can offer you better returns on your investment. The Exchange-Traded Fund (ETF) market now offers you the opportunity to invest in baskets of US-based stocks and other international equity securities for low management expense ratios (MERs).
Another major development in the ETF market is the advent of twin foreign index funds. These identical funds offer one major difference: One includes a hedge against currency fluctuations, while the other doesn’t. The question is: which of the two is better when you consider hedged vs. unhedged ETFs in Canada?
This post will tell you what you need to know about currency-hedged ETFs to help you make a more informed decision on which type of ETF would suit your investment objectives and risk tolerance better.
What Is A Currency-Hedged ETF?
Currency hedged ETFs offer you the ability to choose international investment exposure that removes currency fluctuations from the equation to protect your invested capital from the negative impact on the value of your exposure to international securities.
Investing in international equities without currency hedging essentially means you are taking on additional exposure through foreign currency and exchange rate movements.
The currency exchange rate movements of the Canadian dollar versus other currencies, like the US dollar, can negatively or positively impact the value of your investment returns when the value of one currency changes against that of the other.
Currency hedging is designed to allow you to hold the same foreign equity securities without fluctuations in currency exchange rates impacting your returns.
Suppose you have invested in a fund that tracks the S&P 500 Index that tracks the performance of the top 500 large-cap publicly traded companies in the US stock market and hedges it against the Canadian dollar. In that case, a 10% gain in the index would directly reflect in 10% gains for the fund, minus expenses.
Similarly, let’s say you invested in the unhedged version of the fund that tracks the same index, and the value of the US dollar decreases by 5%. It means that you would see a rise of only 5% due to the decrease in the US dollar value.
The reverse is also true because a rising dollar value could increase the value beyond the gains posted by the index being tracked by the fund.
Are Currency-Hedged ETFs Good?
To say that currency-hedged ETFs are good or bad would be an unfair oversimplification. These exchange-traded funds can be very good for some investors and the opposite for other investors, depending on the asset allocation of the funds and your goal with the investment.
For the sake of making it easier for you to understand the impact of currency hedging in ETFs on your investor returns, I will focus on the performance of twin ETFs that try to emulate the performance of the S&P 500 Index.
The funds tracking this index are exposed to a single currency (the US dollar), making it easier to identify the factors that impact how good or bad currency hedging can be for your investor returns.
I consider saying that currency hedging strategies “eliminate currency risk” is a misleading statement since it implies that non-hedged ETFs are riskier than their currency-hedged counterparts.
However, Canadian investors might find that adding currency diversification to your portfolio can lower the volatility of their portfolios.
The US dollar traditionally has a negative correlation with global stock markets. When markets are going through a downturn, many investors worldwide turn to the US dollar as a safe-haven asset, driving up its value.
Even the Canada Pension Plan Investment Board (CPPIB) holds billions in foreign assets without relying on currency hedging to “eliminate currency risk” because that is not necessarily true.
Why Invest In Currency-Hedged ETFs?
Here are some of the reasons that could help you consider currency-hedged ETFs:
1. Your Portfolio Consists Largely Of US Stocks
If your investment portfolio’s allocation to US-based equity securities is minimal, the exchange rate fluctuations of the US dollar will not have a significant impact on your portfolio.
However, if your portfolio is heavily weighted towards US stocks, a drop in the US dollar’s value against its Canadian counterpart can have a significant impact on your portfolio’s performance.
However, the reverse can also apply to a heavily US-weighted portfolio. An unhedged ETF that holds mostly US stocks can provide more significant returns due to favorable exchange rates when the loonie rises.
If you are planning to live your life here and retire in Canada, a majority of your expenses, in the long run, will likely be in Canadian dollars. You might not be too keen on currency exchange rates making your investment returns unpredictable.
The US dollar generally tends to be stronger than the Canadian dollar, but that does not mean it cannot decline in value. Such instances have happened in the past where the US dollar became significantly weak, like between 2001 and 2007.
The US stock market also underperformed the Canadian stock market during that period, making matters worse.
Many investors worried about the risk with US stocks exited their positions, right before a massive golden era for the US dollar and the US stock market. If currency hedging can help you hold onto your shares in the US market, it would make sense for you to consider it.
Why Invest In Non-Hedged ETFs?
Here are some of the compelling arguments for when currency-hedged ETFs could be better:
The US dollar tends to become the go-to safe haven for investors worldwide during major crises in global markets. The result is a significant boost in its value, and that could mean your losses incurred by US-based equity securities can still be mitigated by the currency appreciation.
The best example to understand this is the performance of the S&P 500 Index during the financial crisis of 2008. The index declined by 37% in terms of its performance in the local currency.
However, the losses were significantly lower at 23% once converted into Canadian dollars. The same thing happened during the pandemic-induced sell-off frenzy in February and March 2020.
It is impossible to completely avoid losses during bear market conditions. As an investor, you should not try to avoid what is inevitable. Instead, it is better for you to structure your portfolio to offset the losses you might incur from such periods. Gaining exposure to the US dollar could prove to be effective for this purpose.
If you plan to make a few trips across the border or plan on purchasing property in the US, having the local currency exposure can be more favorable for you.
Currency-hedged funds are excellent for investors who have a low tolerance for currency risk. Not having such funds would require managing a portfolio of currency forward contracts to get that hedge, and not every investor has the time to learn how to do that.
Currency-hedged ETFs offer you the convenience of hands-off exposure to baskets of foreign securities hedged to the Canadian dollar.
However, currency hedging is not perfect, even when professional fund managers do it. As soon as the value of the stock in a portfolio fluctuates, the amount of the currency forward contracts can become too low or too high. The slight imperfection in hedging is called the residual-currency effect (RCE).
Theoretically, the RCE tends to cancel itself in the long run if the US dollar and the S&P 500 Index fluctuate separately. However, the correlation of the two has actually been proven to be negative since the adoption of the floating exchange rate system back in 1971.
Based on comparing the performance of hedged and unhedged funds since 2000, the yearly cost of RCE and transaction costs to S&P 500 hedged fund investors was almost 1%. Since then, this figure has gone down considerably, but RCE has still annually cost 0.67% on average.
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Our Final Thoughts: To Hedge Or Not To Hedge?
To hedge or not to hedge? That is the question about hedged vs. unhedged ETFs that has a tricky answer.
Currency hedging can work when the Canadian dollar is going strong, but unhedged ETFs might prove to outperform their currency-hedged counterparts when the Canadian dollar is becoming weaker against the US dollar.
Canadian investors who expect the Canadian dollar to fall may feel tempted to switch to unhedged ETFs instead.
If you stick with currency-hedged ETFs during periods of a stronger Canadian dollar but time switching to unhedged ETFs when it is about to fall, you could do well with gaining exposure to either one at a given time.
Unfortunately, it is impossible to reliably predict currency movements. Additionally, switching between ETFs in a non-registered account could eat into any profits through taxes even if you make the correct call.
Ideally, it pays to settle on a long-term strategy and stick to it based on your better understanding. I prefer unhedged ETFs, particularly because of the effects of a rising loonie during bull market environments across the border.
Which one is better for you is up to what you prefer. If you want to gain unhedged exposure to the US stock market, my iShares XUS ETF Review can help you identify a fund that you could consider adding to your portfolio.