Investment Commentary – July 2014

Currency Hedging from a Canadian Investor’s Perspective

With Canada representing just 3% of global investment opportunities, Canadians tend to look abroad when constructing suitably diversified portfolios. For this reason, fluctuations in the loonie vis-à-vis other currencies can significantly affect the performance of a Canadian investor’s portfolio. For example, in the most recent quarter US stocks – as measured by the S&P 500 Index – gained 5.23% in local currency (i.e. US dollar) terms. However, with the Canadian dollar appreciating over the last three months, the return of US equities in Canadian dollar terms was just 1.64%.

At first glance, this would suggest that Canadian mutual funds and ETFs that hedge foreign currency exposure would be the best choice. However, the world of investing is seldom black and white. From the perspective of a Canadian investor, research shows that a completely unhedged portfolio would actually be the least volatile! The same was true for Australian investors. These “commodity currencies” are closely tied to the prices of oil and other natural resources, which drive their foreign exchange values. Essentially, it causes these cyclical currencies to also be positively correlated to global stocks, mirroring the advances and declines of the market cycle. On the other hand, exposure to foreign currencies – many of which tend to be negatively correlated with equities – decreases portfolio volatility for Canadians through additional diversification.

The graph above highlights this point. A hedged investment vehicle should provide you with the local currency return of a foreign market. In this case, we use the rolling 3-year volatility of the S&P 500 Index in local currency terms as a proxy for a currency hedged US equity strategy (in blue). We compare this to the volatility of the S&P 500 Index in Canadian dollar terms, which takes into account both the return of US stocks as well as currency fluctuations (in red). Over the last twenty-five years through June 2014, hedging foreign currency risk resulted in higher volatility most of the time. In fact, since the financial crisis – a time when Canadian investors certainly needed diversification – maintaining exposure to US Dollars decreased volatility by an average of 6% per year.

Furthermore, while foreign exchange risk can have an impact on a Canadian investor’s return in the short run, over several years the difference between hedged and non-hedged strategies is usually quite small. Looking at rolling 20-year investment horizons, employing a currency hedge for your US Equity allocation provided a 0.35% better return per year on average. Not insignificant, though it is important to note that this assumes a perfect hedge. In practice, hedging currency exposure is neither perfectly precise nor free. In fact, the high tracking error (deviation from the benchmark) associated with hedged vehicles often reduces or completely negates their benefit.

At TEIC, we believe that currency hedging is an unnecessary and costly endeavor, especially for long-term Canadian investors. Specifically, currency hedging tends to increase risk and seldom delivers any incremental net returns. While we recognize that exchange rate fluctuations can be volatile over short periods, for these reasons we avoid hedged instruments as much as possible. We are quite encouraged by the recent proliferation of unhedged investment options for Canadian investors, especially in the International Equity asset class. It seems that an increasing number of Canadian investors are finding that different risk exposures may in fact reduce volatility over time.

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These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.

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