Investing in countries outside of Canada has never been easier, with easy access to international ETFs and stocks on most trading platforms.
However, by doing so, you are exposing yourself to currency risk. If you’re an ETF investor, there are options to mitigate this; you can purchase currency-hedged ETFs.
But is that a good choice? Out of all the hedged vs. unhedged ETFs in Canada that are available, which ones should you choose? Let’s try to find out below.
Factors Influencing Choice of Hedged Vs. Unhedged ETFs
The debate between hedged and unhedged ETFs is an ongoing one. While both have their merits, the ultimate decision often rests on several key influencing factors:
- Investment Objectives: Your time horizon plays a pivotal role. If you’re investing for a specific short-term goal, like buying a home in a few years, hedged ETFs can offer more predictability by negating currency risk. Conversely, if you have a long-term view, unhedged ETFs can capitalize on both stock and currency appreciation over time.
- Risk Tolerance: How comfortable are you with volatility? Currency fluctuations can introduce an additional layer of volatility into your portfolio. Hedged ETFs aim to remove this currency risk, offering a smoother investment journey. However, by doing so, you might also miss out on potential gains from currency appreciation.
- Market Outlook: Your predictions about global economic trends can heavily influence your choice. If you foresee prolonged instability or economic downturns in specific regions, you might be inclined to shield your investments from currency risks associated with those regions through hedged ETFs.
- Cost Implications: Hedging doesn’t come free. The costs associated with hedging strategies can erode returns over time. It’s essential to weigh these costs against the potential benefits of currency hedging.
What Is A Currency-Hedged ETF?
Currency-hedged ETFs offer you the ability to choose international investment exposure that attempts to remove currency risk.
Investing in international equities without currency hedging means you are taking on additional currency risk exposure through foreign currency 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.
Example of currency hedging (hedged): Suppose you have invested in a fund that tracks the S&P 500 Index, (such as Vanguard VSP) and currency-hedges it against the Canadian dollar. If USD loses 10% in value over the CAD, there is no loss to your ETF because it is currency-hedged.
Example of currency hedging (unhedged): Similarly, let’s say you invested in the unhedged version of the fund that tracks the same index (Vanguard VFV). If the USD loses 10% in value over the CAD, the fund will lose 10% of the 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 their portfolios 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 favourable 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 when 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 of US stocks exiting 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 avoid losses during bear market conditions completely. 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.
2. Currency Risk Hedging Does Not Outperform in the Long Run
While unhedged ETF performance might see some drastic gain year to year, in the long run, it does not outperform hedged ETFs on average. In fact, because of the higher cost of hedging your currency, hedged ETFs are shown to underperform unhedged ETFs in the long term.
3. Currency Risk Hedging Is Not Perfect
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 between 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.
4. You Will Require US Dollars In The Future
If you plan to make a few trips across the border or plan on purchasing property in the US, having local currency exposure can be more favourable for you.
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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.
Canadian investors who expect the Canadian dollar to fall may feel tempted to switch to unhedged ETFs instead.
Unfortunately, it is impossible to predict currency movements reliably. I prefer unhedged ETFs, as hedged ETFs are not proven to outperform in the long term.
Ideally, it pays to settle on a long-term strategy and stick to it based on your better understanding.
Which one is better for you is up to what you prefer. If you want more options for S&P 500 ETFs, check out this article.