Tag Archives: US dollar

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…

Canadian ETFs versus US ETFs

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By Michael J. Wiener, Michael James on Money

Special to the Financial Independence Hub

When it comes to investing, we should keep things as simple as possible. But we should also keep costs as low as possible. These two goals are at odds when it comes to choosing between Canadian and U.S. exchange-traded funds (ETFs). However, there is a good compromise solution.

First of all, when we say an ETF is Canadian, we’re not referring to the investments it holds. For example, a Canadian ETF might hold U.S. or foreign stocks. Canadian ETFs trade in Canadian dollars and are sold in Canada. Similarly, U.S. ETFs trade in U.S. dollars and are sold in the U.S. Canadians can buy U.S. ETFs through Canadian discount brokers but must trade them in U.S. dollars.

Vanguard Canada offers “asset allocation ETFs” that simplify investing greatly. One such ETF has the ticker VEQT. This ETF holds a mix of Canadian, U.S., and foreign stocks in fixed percentages, and Vanguard handles the rebalancing within VEQT to maintain these fixed percentages. An investor who likes this mix of global stocks could buy VEQT for his or her entire portfolio without having to worry about currency exchanges. It’s hard to imagine a simpler approach to investing.

Investors who prefer to own bonds as well as stocks can choose other asset-allocation ETFs offered by Vanguard Canada, BlackRock Canada, or BMO. But the idea remains the same: we own just the one ETF across our entire portfolios. For the rest of this article we’ll focus on VEQT, but the ideas can be used for any other asset-allocation ETF.

Why would anyone want to own a set of U.S. ETFs instead of just holding VEQT? Cost. It’s more work to own U.S. ETFs and trade them in U.S. dollars, but their costs are much lower. To see how much lower, we need to find a mix of U.S. ETFs that closely approximates the investments within VEQT. Readers not interested in the gory details of finding this mix of U.S. ETFs can skip the end of the upcoming subsection. 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…

When and when not to hedge currency risk

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depositphotos_16811249_s-2015-2By Tyler Mordy, Forstrong Global Asset Management

Special to the Financial Independence Hub

 An old Japanese proverb states “many a false step was made by standing still.”

So it is with currency exposures in investor portfolios. Consider the recent experience of Brazilian, Russian and even Canadian investors — to name a few countries with steeply depreciating exchange rates. By electing to remain invested in their domestic currency, they have all experienced a steep “loss” in their own global purchasing power (even if nominal values held up). An ostensibly conservative position has cost them dearly.

Welcome to the new, hyper-globalized world. Since the financial crisis, unorthodox policies — with central banks trying to outdo the effects of one another by plunging into a subterranean universe of quantitative easing and negative interest rates — have driven currency volatility much higher. Now, capital has a way of swiftly seeking out safe harbours and penalizing others who are not safeguarding their national currencies. Who would have thought the once-august Swiss franc would lose its safe haven status?

currency-chart-1-nov-2016

Indeed, currency exposures are having an outsized impact on portfolio returns. Currency-focused ETF vehicles could not have arrived at a better time, introducing yet another evolution in the portfolio management process.  Today, gaining global currency exposures is as easy as buying stocks.

Beyond the academic view

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…