Tag Archives: currency hedging

To Hedge FX Risk, or not to Hedge

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To Hedge FX Risk, or Not to Hedge: Currency markets are notoriously difficult to call but can meaningfully impact portfolio returns. ETF Strategist Bipan Rai provides a detailed framework for investing outside the Canadian market.

Image Getty Images courtesy BMO ETFs

By Bipan Rai,  BMO Global Asset Management

(Sponsor Blog)

Admittedly, using a spin on a famous Shakespeare quote to start a note on currency hedging1 is verging on trite. Nevertheless, if Hamlet were running a portfolio of overseas assets, his primary concern would have to be the “slings and arrows” of currency markets — which are notoriously difficult to call but can meaningfully impact portfolio returns.

For Canadian investors, looking abroad provides several benefits. The most important is diversification, whether it’s through access to other regions that are less correlated with Canadian markets or to other products that aren’t available domestically.

However, investing abroad also means taking on foreign exchange risk given that international assets are priced in currencies other than the Canadian dollar (CAD).

For illustrative purposes, consider Chart 1, which shows the total return for the S&P 500 in U.S. dollars (USD) and in CAD terms for Q1 of this year. In USD terms, the index was up 10.6% over that time frame, but since that period also corresponded to weakness in the CAD relative to the USD (or USD/CAD moved higher) the index outperformed in CAD terms (up 13.3%). That means that Canadian investors would have fared much better leaving their USD exposure unhedged ex ante.

Chart 1 – S&P 500 Total Return for Q1 2024

Source: BMO Global Asset Management

Now let’s look at an alternative period in which the CAD strengthened against the USD. Chart 2 shows a comparison of the total return for the S&P 500 from April 2020 to April 2021 (in which USD/CAD was lower by over 11%). During that period, the total return index outperformed in USD terms by close to 20%. In this scenario, an investor who had hedged their FX risk would have been in the optimal position.

Chart 2 – S&P 500 Total Return Between April 2020 – April 2021

Source: BMO Global Asset Management

As these examples show, currency risk is a key consideration for any investor who wants to look beyond Canada for diversification. That risk can cut both ways, which amplifies the importance of hedging decisions. In our minds, the decision to hedge foreign exchange (FX )risk (including the degree to which foreign exposure is hedged) comes down to the following:

  1. An investor’s view of the underlying currency pair
  2. Whether the currency pair is positively or negatively correlated2 with the underlying asset

In this note, we’ll make a brief comment on the first point but focus largely on the second one. as we feel that should be given more weight for hedging decisions.

FX Markets are Tough to Call

Taking a view on the underlying currency pair is easy to do — but difficult to capitalize on.

Indeed, foreign exchange markets are notoriously fickle. One reason why is the relationship between predictive factors and currency pairs is rarely stationary. For instance, a lot of market participants tend to use front-end (2-year) yield spreads as a proxy for central bank divergence in the spot FX market. Chart 3 shows the current correlation between those spreads and the different CAD crosses, and as expected, the relationship isn’t consistent from a cross-sectional perspective.

Chart 3 – Correlation Between Two-Year Spreads and the CAD Crosses

* * Correlation window is 2 years. The CAD is used as a base currency for this analysis. The spread is tabulated by subtracting the foreign 2-year yield from the CAD 2-year yield. Source: Bloomberg, BMO Global Asset Management.

We can also see this by looking closer at the relationship between a factor and a currency pair over time. Chart 4 shows the rolling 100-day correlation between USD/CAD and the price of oil (proxied by the prompt WTI contract3) going back ten years. Note how frequently the strength of the correlation (as well as the sign) changes over time. Continue Reading…

Hedged vs Unhedged ETFs explained

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Currency hedging can impact an ETF’s price and overall performance; learn about hedged and unhedged ETFs in Canada here.

 

By David Kitai, Harvest ETFs

(Sponsor Content)

The idea behind an ETF is relatively simple. At the most basic level, an ETF issuer creates a basket of securities and lists that basket on a stock exchange for investors to buy and sell. The ETF tracks the value of that basket and moves on the market accordingly.

The trouble is, nothing is ever quite so simple. Many Canadian investors want exposure to US securities, as US markets are the largest and most important in the world. What happens when the securities an ETF issuer uses are based in the US, and trade in US dollars, but their ETF will be listed on the TSX and trade in Canadian dollars?

Now, two factors are impacting the ETF: the value of its basket of securities, and the fluctuating exchange rate between USD and CAD. That means, regardless of the value of its holdings, if the USD goes up, the value of the ETF will also go up. If the USD falls, the ETF will also fall. This is called currency risk.

Some ETFs will employ a strategy called currency hedging to minimize the impact of currency risk on an ETF’s value. Those ETFs will usually be described as “Hedged CAD.”

What “Hedged CAD” means

Generally, when an ETF is Hedged to CAD its portfolio managers use a tool called a “currency forward” to lock in a specific exchange rate on a future date. In our Canadian ETF holding US securities example, if the USD has fallen by that date, the ETF makes a gain from the contract which offsets the value it lost from a falling USD on the portfolio holdings. If the USD has risen, the ETF nets a loss from the contract, which also offsets the value it gained from the rising USD.

The goal of currency hedging is not to maximize returns: the goal is to reduce the impact from currency risk as much as possible.

Harvest offers both hedged and unhedged ETFs in its lineup. A select group of Harvest Equity Income ETFs offer a Hedged “A” series and an unhedged “B” series to suit the goals of different investors. You can find a schedule of hedged and unhedged ETFs here.

Hedged vs Unhedged ETFs

So why would some investors want an unhedged ETF? The answer can vary somewhat. Currency hedging also comes with a small cost that is factored into performance over time.

Some investors may buy an unhedged ETF because they want to take on  exposure to currency risk. Some investors want to be exposed to certain currencies, and getting currency exposure through an ETF holding foreign securities is one way to achieve that. If an investor believes in the thesis behind a specific ETF, for example the US healthcare sector, and also believes the USD will rise against the Canadian dollar, then buying the unhedged “B” series of the Harvest Healthcare Leaders Income ETF (HHL:TSX) would give them exposure to both a basket of US healthcare stocks and the value of the US dollar against the Canadian dollar. Continue Reading…

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…

Finance 101: How currency hedging affects your investment return

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By Neville Joanes

(Sponsor Content)

If you invest overseas, your holdings may be valued in foreign currency. When markets are volatile, a portfolio manager can use currency hedging to protect the value of the investment.

Let’s look at how currency changes can affect how your money works. For instance, let’s say you book a vacation in Miami, Florida for your family. You’ll fly down from Toronto and enjoy some fun in the sun in the wintertime. You can relax while your kids cool off in the hotel swimming pool.

But between booking your reservation in the summer and actually paying your bill at the end of your stay in January, you notice that your costs jumped nearly 10 per cent – even though the bill in US dollars was the same as when you booked it months before! What gives?

If you had purchased US dollars at the time you booked and paid for your vacation with it, you’d be fine. But you used a credit card (like most folks), and had to pay the difference in the value of the currency. Now the vacation is over and you spent more than you intended.

A similar thing can happen with investments. Let’s see how it works.

Non-hedged vs. hedged investing: a simple example

Imagine a Canadian investor with diversified, international holdings. A few months ago, they bought some tech stocks that looked ready to go up. And lo and behold, they did! Their US tech company stock went up 8 per cent (measured in US dollars).

But there was another factor working against this investor: Canada! Surging oil prices powered the economy ahead at full speed. The Canadian dollar appreciated by an impressive 6 per cent against the US dollar!

What’s the result of this non-hedged investment? The investor’s US tech stock investment gives them a positive return of just 2 per cent. Not so impressive.

What would have happened if the investor hedged their investment? In that case, the investor gets the full 8 percent return!

See, hedging is like an insurance policy, when volatility is high. But here’s the catch: hedging is complicated. It’s time-consuming. You need high-level expertise and bandwidth to watch the market carefully.

For most Canadian investors, that’s not an option. It’s probably something you want to let your portfolio manager (like ours) take care of for you.

Hedging on an income stream to ensure steady returns. That’s how we do it

Let’s say there is an income stream from a dividend-paying investment, like in our bond and income-generating ETFs. That income stream is where we look to hedge the investment. Continue Reading…

Falling Loonie strategies

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The Canadian dollar or loonie is under pressure amid weak oil prices and a strengthening U.S. currency. Today, the loonie dropped to 78.39 cents for a U.S dollar the lowest in a many years.By Adrian Mastracci, KCM Wealth

Special to the Financial Independence Hub

“Investors who have US cash and/or US portfolios are advised to revisit their currency strategies.”

Canada’s Loonie has been falling to under 70 Cents against the US Dollar.
Recall it climbed from near 86 cents in mid-2009 to over parity.

Many market forces, such as currencies, are well beyond investor control.
Currency adds yet another potential hazard or reward to portfolios.

Of course, currencies are extremely hard to predict. They can also move very quickly in either direction.

Treat currency as an asset class

Treat currency as an investment with longer time horizons. Those with US cash and/or US portfolio may consider the merits, if any, of converting to Canadian Dollars.

It is important to get a handle on the Canadian tax cost of the US cash/portfolio before taking any action. It may also make good sense, depending on account values, to convert on more than one occasion.

Other considerations: Continue Reading…