Tuesday, 1 December 2009

Foreign Investments: To Hedge or Not to Hedge Currency

Investors who take up the advice to diversify by broadening their investments to foreign holdings must face the issue of whether to hedge the foreign exchange.

Hedging means an attempt to remove the effects of foreign currency fluctuations so that, for instance, a 10% gain in a US equity fund denominated in US dollars (USD), remains a 10% gain when translated into Canadian dollars (CAD). Without hedging, a 10% rise in the Canadian dollar would completely offset the US fund gain. Of course, the effect works the other way too - a falling Canadian dollar boosts foreign returns. Last fall the drastic fall in the Canadian dollar against the USD cushioned the effect of the market crash, as noted in a post at the time A Falling Canadian Dollar Can be an Investor's Friend. Given the two-way potential of foreign currency influences, is hedging worth doing for the average individual investor?

For and Against:
  • over long periods of 15 years or more, academic research shows that there is little or no difference in returns between hedged and unhedged portfolios except for hedging costs - e.g. Hedging Currencies with Hindsight and Regret and Currency Risks in International Equity Portfolios
  • within the short term, such as a few years, currency shifts can be quite large and the shifts can reverse course quickly, possibly overwhelming the actual stock or fund return. Compare the following two charts from RatesFX of the CAD vs other major currencies as of October 26, 2009 where blue indicates CAD appreciation and red, depreciation - over one year CAD was up 18% over the USD, 2% over the Euro, 17% over Pound Sterling and 12% over the Japanese Yen. These rises would be all bad for the Canadian investor. Over the past three years, the story changes: the rise was only 7% against the USD, 20% over the GBP but there was decline of 11% versus the Euro and 19% versus the Japanese Yen. It is a mixed bag - the CAD appreciation being bad, the declines good.

  • foreign currency shifts are very hard if not impossible to predict so deciding to hedge when expecting CAD appreciation is a strategy prone to a lot of uncertainty and error
  • from the perspective of inflation, not hedging makes sense - when the CAD falls foreign goods cost more, so getting a boost from unhedged foreign returns benefits the investor/consumer while CAD appreciation lowers inflation, offsetting some of the lowered investment return.
  • along the same lines, if you spend in a foreign currency, for example travelling or living in the US or Europe, then having assets tied to those foreign currencies alleviates currency risk
  • foreign equities have had positive returns both during multi-year periods when the CAD was appreciating or when depreciating. Keith Matthews' excellent book The Empowered Investor has a table showing that in 1985 to 1991 while the CAD appreciated, returns in Canadian dollars on both US and international equities nevertheless far outstripped returns from Canadian companies
  • hedging costs money to implement and it does not do a perfect job as the discussion below on how to do hedging shows, most often resulting in reduced returns
  • currency shifts themselves appear to account for a portion of the non-correlated movement of non-Canadian securities (see Table 4 Co movements from UBC Sauder School of Business Pacific Exchange Rate Service); thus, currency exposure enhances the risk-reducing diversification within a portfolio
Ways to Hedge
  • currency futures, forward contracts and options used by companies and institutional investors are not really practical for individual investors
  • the most common and easiest way to hedge is to buy ETFs or mutual funds that are labelled "hedged" or "currency neutral". Two such popular ETFs and their corresponding ETFs traded in the US are listed below. The costs of hedging manifest themselves in higher fund MERs and tracking error, as Larry MacDonald explains in a piece on Seeking Alpha called On Currency Hedging and the US Dollar. The graphs show the recent under-performance of hedged funds compared to the reference benchmark that is often the result.
  1. iShares CDN S&P 500 Hedged to Canadian Dollars Index Fund (TSX symbol XSP) and iShares S&P 500 Index Fund (NYSE: IVV). XSP's return lags IVV's, but without the hedging, a Canadian investor in IVV would have gained only 1.8% since January 1st, 2009 (not including the 1% or so further that would be lost when paid to the broker to convert an IVV sale in USD to CAD) instead of the 19% gain of XSP.
  2. iShares CDN MSCI EAFE Hedged to Canadian Dollars Index Fund (TSX: XIN) and iShares MSCI EAFE Index Fund (MYSE: EFA)
Bottom line: though the number of arguments appear to favour not hedging foreign holdings, the key is having a long time horizon since in the short term, there is the possibility of drastically lowered or even negative returns (though it can go the other way too). In the short term, it's just a lot more risky. Again, the investor needs to keep objectives and time horizons in mind to make a good decision on whether or not to hedge.

Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations.


Anonymous said...

Very Interesting!
Thank You!

Anonymous said...

Hi, I found the piece very informative, I have a 15 year horizon, how would the author define "long-term" versus "short-term"?

CanadianInvestor said...

Anon, re short vs long term, 15 years is the working definition since that is about how long it has taken in the past for hedged vs non-hedged portfolios to even out.