Building Wealth

For the first 30 or so years of working, saving and investing, you’ll be first in the mode of getting out of the hole (paying down debt), and then building your net worth (that’s wealth accumulation.). But don’t forget, wealth accumulation isn’t the ultimate goal. Decumulation is! (a separate category here at the Hub).

Should I hedge? Hedged vs. Unhedged ETFs in Canada

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By Bob Lai, Tawcan
Special to the Financial Independence Hub

 

When you look at the TSX composite, you will notice that the financial and energy sectors make up a large percentage of the index. In fact, the financial sector constitutes over 30% and the energy sector almost 15% of the TSX. If you want a heavier weighting in the consumer staples, consumer discretionary, technology, or health care sectors in your portfolio, it almost always means you have to invest outside of the Canadian market.

For most investors, the easiest way to diversify outside of Canada is utilizing one of the many low-cost index ETFs available. When investing outside of Canada, one of the things to consider is currency exchange rates because they can either work for you or against you.

Hence, investors must answer this very important question: should you utilize currency-hedged ETFs? Or should you ignore the currency exchange rate risk and go with unhedged ETFs?

Hedged vs. unhedged ETFs, which one should you choose? It’s an important and complicated question. Let’s take a closer look.

What is currency hedging? 

I’ll be honest. When I first started doing DIY investing, I didn’t understand what currency hedging meant. The term confused me for a very long time.

Think of currency hedging like buying car or house insurance. You’re buying and paying for the insurance to protect yourself from an unforeseen event that could cause you to lose a lot of money.

In layman’s terms, currency hedging is a strategy to reduce the effects of currency fluctuations. You’re betting that the foreign currency, usually the US dollar, will weaken against the Canadian dollar. In other words, currency hedging allows you to hold foreign equities without worrying about currency fluctuations and impacting your overall return.

Say you decide to invest in the broad US equity market and the market returned 15% over the past year. During the same year, the US dollar weakened against the Canadian dollar by 10%.

If you invested in an unhedged US broad equity market index ETF, you’d only see a return of 5% minus expenses. The overall return is not 15% because the 10% currency fluctuation has eaten into your returns.

In this scenario, you’d benefit from investing in a hedged US broad equity market index ETF and end up with a return of 15% minus expenses.

Currency hedging isn’t all sunshine and rainbows though. Just as it can work in your favour, as with the above example, it can also go against you. For example, if the US dollar strengthens against the Canadian dollar by 10% during that same time period, you’d end up with a return of 25% minus expenses with an unhedged ETF but only a return of 5% with a hedged ETF. That’s a significant difference!

How do ETF managers hedge currencies? 

How do ETF managers hedge and manage risk caused by currency fluctuation? Can’t the average investors like you and me do the same, deploy similar strategies, and avoid paying the ETF management fees?

Well, ETF managers hedge by purchasing assets and instruments to offset currency exposure. ETF managers can buy forward contracts by entering into an agreement to exchange a fixed amount of currency at a future date and a specified rate. They can also use future contracts, currency options to hedge against potential currency risks. These assets and instruments are usually adjusted every month to ensure proper exposure to currency exchange rate risks.

If all that sounds complicated to you, well it is. This is why hedging isn’t something the average investor can easily do. Hedging, as it turns out, is best to leave it to the experts.

Are currency-hedged ETFs good? Should you always invest in currency-hedged ETFs so you don’t have to worry about currency fluctuation and can sleep like a baby?

Well, the answer is complicated. Turns out, there are many factors that investors need to evaluate before deciding whether to use a currency-hedged ETF or not.

Before we go through these reasons, let’s take a look at the pros and cons of currency-hedged ETFs.

Pros of currency-hedged ETFs

The biggest advantage of currency-hedged ETFs is that you are protecting yourself from any unforeseen (major) currency fluctuation. Essentially, what you see is what you get – you get the true value of the underlying holdings without having to worry about currency exchange rates. This is one of the advantages of CDRs.

For many investors, this can provide peace of mind and simplify investing in foreign markets.

Cons of currency-hedged ETFs 

As you can imagine, there’s a cost associated with buying and selling forward and future contracts, options, and other derivatives to offset currency exposure. As a result, currency-hedged ETFs typically have higher management fees compared to their unhedged counterparts.

For example, VSP, the CAD-hedged Vanguard S&P 500 index ETF, has an MER of 0.09%. Meanwhile, its unhedged counterpart, VFV, has an MER of 0.08%.

Even if management fees are the same between hedged and unhedged ETFs, there are potential hidden costs like higher turnover rates.

For example, even though the hedged and unhedged Vanguard US Total Market ETFs, VUS and VUN, have the same MER, VUS, the hedged version, has a portfolio turnover rate of 23.38% while VUN the unhedged version only has a portfolio turnover rate of 8.31%. Higher turnover rates typically mean more transaction costs, which can lead to lower returns in the long run.

Furthermore, currency hedging doesn’t always work for you. When the currency fluctuation goes the other way, currency hedging can lead to a lower return. So be careful when people claim that currency hedging will eliminate all currency risks and that you should ALWAYS invest in currency-hedged products! In my opinion, when it comes to investing, there’s no such thing as ‘ALWAYS.”

Why invest in currency-hedged ETFs? 

Given the pros and cons, who is best suited to invest in currency-hedged ETFs? As it turns out, it depends on your risk tolerance and your investment timeline. Here are a few reasons why you’d invest in currency-hedged ETFs.

If we look at the US dollar and Canadian dollar, the all time high was 1.600 in January 2002 and an all time low of 0.948 in October 1959. Over the last 30 years, the historical average has been 1.243.

As of writing, the exchange rate is 1.275 which is stronger than the 30-year historical average.  But only slightly! This means there’s a decent chance the US dollar will weaken against the Canadian dollar. However, there are far too many geo-political and geo-economic factors that could possibly arise that no one can accurately predict which way the exchange rate will go in the near, and certainly, in the more distant, future.

If your investment timeline is short, you probably want to protect yourself from the potential weakening of the US dollar. Therefore, it may make sense to pay the extra management fees and use currency-hedged ETFs to smooth out currency fluctuations. On the other hand, if you have a longer investing time horizon, it is probably wise not to go with the hedged option.

2. If you hold a large percentage of foreign equities

If your portfolio is largely allocated to markets outside of Canada, fluctuation in foreign exchange rates can quickly decrease your returns. Using currency-hedged ETFs is a simple way to potentially lock in your returns and not worry about the inverse effects of adverse currency fluctuation.

3. You have low risk tolerance

If you are risk averse, currency hedging can potentially reduce the volatility caused by currency exchange rates. By removing currency exchange rates out of the equation, it’s one less thing to worry about for risk averse investors, allowing them to sleep better at night.

Why invest in unhedged ETFs 

On the flip side, there are many reasons why one may want to consider investing in unhedged ETFs. Continue Reading…

Relationship between Inflation and Asset Price Returns

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By Myron Genyk,  Evermore Capital

Special to Financial Independence Hub

You see lots of people on business channels and investing blogs talking about the types of things to invest in when inflation is high – energy stocks, material stocks, value stocks, dividend growth stocks, floating rate bonds, inflation bonds, oil, copper, gold, silver, crypto, etc. OH MY! – and what types of investments you should avoid.  On the surface, it’s pretty reasonable advice. 

“Of course!!  I should be invested in something that does well when inflation is high!  Inflation is high now!  And everyone says it’s going to continue like this for a long time!  And I want my investments to grow!”  But before we go leaping and investing in whatever it is that’s great during inflationary times, let’s explore the soundness of the argument itself.

The Tautology of it all

I’m always a little amused when people say things like:

“When market variable X is high (or low), that will cause thing Y to happen, which will cause thing Z to occur, which will cause some asset A to go up (or down).  And so when market variable X is high/low/whatever, then buy (or sell) asset A.  Easy peasy!”

There’s a lot happening there, but at its core, it’s just a chain of events:  X leads to Y leads to Z leads to A going up (or down).  At each step, there are assumptions baked in, assumptions that aren’t exactly baked into the fabric of the universe, but let’s leave that for now.  Because what is more interesting here is that the expression above can be simplified as follows:

“When asset A is going to go up, you should buy asset A.”

This is much cleaner.  It removes all the unnecessary hand-waving (but, perhaps the hand-waving IS necessary … but by whom?  And for what purpose?) and lays bare what is actually being said:

“Buy things before they go up in value.” Continue Reading…

Retirement Options for Small Business Owners

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By John Shrewsbury, RICP

Special to Financial Independence Hub

As a small business owner who is emotionally, physically, mentally, and financially engaged in a growing startup, you may feel consumed in the now. So many small business owners put everything back into their company without setting aside their profits in a tax-efficient way. If you run your business without an eye to the future, you will never reach the point where work becomes optional. Your business is your vehicle to financial independence, but it won’t happen without years of careful preparation.  

The independence and freedom of your entrepreneurial path comes with an array of responsibilities. As the business owner, the weight of preparing for your retirement and the retirement of your employees falls entirely on your shoulders. After all, if you don’t plan for your retirement, who will? Start building retirement savings into your company budget and making it a part of your compensation for running the company.

Business owners in the U.S. have retirement options for many situations

As a small business owner, you have a retirement option for almost every situation. When choosing a plan, your most significant consideration is the cost of contributing. If you can only afford to set aside a small amount of money each year, an individual retirement account (IRA) will serve you well. 

A Simplified Employee Pension plan (SEP) is the equivalent of a jumbo IRA. This plan works best for self-employed entrepreneurs with few or no employees. You can contribute up to 25% of your compensation to a SEP, with a maximum of $61,000 per year allowable in 2022. Keep in mind that if you have eligible employees, an SEP requires you to contribute an equal percentage of their salaries to the percentage you contribute from your own revenue. For example, a business owner with an employee making $100,000 per year would have to contribute 25% of the employee’s salary if they want to maximize their own contribution at 25%. If you have a number of employees, a SEP will most likely be your most expensive option.  Continue Reading…

A Retirement-ready portfolio of Canadian and U.S. stocks

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By Dale Roberts, cutthecrapinvesting

Special to the Financial Independence Hub

In this post I’ll offer up charts on our U.S. stock portfolio and the Canadian stock portfolio. And I’ll put them together so that we can see how they work together. The total portfolio was designed to be retirement-ready. The fact that it beats the market benchmarks is a welcome surprise. At the core of the portfolio is wonderful Canadian dividend payers – the U.S. stocks fill in some portfolio holes. Let’s have a look at our U.S. and Canadian stock portfolio.

I recently received requests to share our U.S. stock portfolio holdings. While I often track that portfolio on Seeking Alpha (the land of stock pickers) that’s not a regular event on this blog. I have certainly shared the Canadian Wide Moat Portfolio on Cut The Crap Investing.

On Seeking Alpha, here is our U.S. stock portfolio. The post may be paywalled for those who have exceeded the 3 free reads on Seeking Alpha. Again, that’s why I will share some details here. But keep in mind, this is not advice. But you may be on the receiving end of some ‘good’ lessons on building the simple stock portfolio.

Skimming the dividend achievers index

In early 2015 I skimmed 15 of the largest-cap dividend achievers. What does skim mean? After extensive research into the portfolio “idea” I simply bought 15 of the largest cap dividend achievers. For more info on the index, have a look at the U.S. Dividend Apprecation Index ETF (VGG.TO) from Vanguard Canada. At the core is a meaningful dividend growth history working in concert with financial health screens. It leads to a high quality skew.

You will find that index ETF in the ETF portfolio for retirees post.

At Questrade you can buy ETFs for free.

I won’t get too deep into the methodology and how and why I constructed our portfolio in this post. I will offer more details in a post next week. Today, I will just get to the fun stuff – the holdings and the return charts and tables.

The U.S. Dividend Achievers

The 15 companies that I purchased in early 2015 are 3M (MMM), PepsiCo (PEP), CVS Health Corporation (CVS), Walmart (WMT), Johnson & Johnson (JNJ), Qualcomm (QCOM), United Technologies, Lowe’s (LOW), Walgreens Boots Alliance (WBA), Medtronic (MDT), Nike (NKE), Abbott Labs (ABT), Colgate-Palmolive (CL), Texas Instruments (TXN) and Microsoft (MSFT). Continue Reading…

Nobody knows what will happen to an Individual Stock

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Image via Pixels/Tima Miroshnichenko

By Michael J. Wiener

Special to the Financial Independence Hub

 

When I’m asked for investment advice and I say “nobody knows what will happen to an individual stock,” I almost always get nodding agreement, but these same people then act as if they know what will happen to their favourite stock.

In a recent case, I was asked for advice a year ago by an employee with stock options.  At the time I asked if the current value of the options was a lot of money to this person, and if so, I suggested selling some and diversifying.  He clearly didn’t want to sell, and he decided that the total amount at stake wasn’t really that much.  But what he was really doing was acting as though he had useful insight into the future of his employer’s stock.

He proceeded to ask others for advice, clearly looking for a different answer from mine.  By continuing to ask others what they thought about the future of his employer’s stock, he was again contradicting his claimed agreement with “nobody knows what will happen to an individual stock.”

How a seemingly token amount can become a painful loss

Fast-forward a year, and those same options are now worth about 15 times less.  Suddenly, that amount that wasn’t that big a deal has become a very painful loss.  He has now taken advantage of a choice his employer offers to receive fewer stock options in return for slightly higher pay.  It’s hard to be sure without seeing the numbers, but in arrangements I’ve seen with other employers, a better strategy is to take the options and just sell them at the first opportunity if the stock is far enough above the strike price.  Again, he’s acting as though he has useful insight into the future of his employer’s stock.

The lesson from this episode isn’t that people should listen to me.  I’m used to people asking me for advice and then having my unwelcome advice ignored.  What I find interesting is that even if I can get someone to say out loud “I don’t know what’s going to happen to any individual stock,” they can’t help but act as though either they know themselves, or they can find someone who does know.

Michael J. Wiener runs the web site Michael James on Money, where he looks for the right answers to personal finance and investing questions. He’s retired from work as a “math guy in high tech” and has been running his website since 2007.  He’s a former mutual fund investor, former stock picker, now index investor. This blog originally appeared on his site on Sept. 20, 2022 and is republished on the Hub with his permission.