Tag Archives: US$

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…

Currency investing may seem appealing but you’ll lose in the long run

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It’s A Rare Investor Who Makes Enough Profit From Long-Term Currency Investing Activities To Compensate For The Risk Involved

As a general rule, we advise against long-term currency investing speculation for many of the same reasons we advise against options trading and bond trading. It’s a rare investor who makes enough profit from these activities to compensate for the risk involved.

Our view is that if you like a currency’s outlook, you should buy stocks that will profit from a rise in that currency. Our longstanding advice is to invest mainly in well-established companies. Avoid exposure to currency trading, penny stocks, new issues, options, futures or any high-risk investments. That way, while you may experience modest losses when markets drop, you should show overall positive results over time.

Keep hedged ETFs as a long-term currency investing strategy out of your portfolio

If you want to buy U.S. stocks and hedge against currency movements, you could buy a hedged ETF.

Hedged ETFs, like, say, the iShares Core S&P 500 ETF (symbol XUS on Toronto) are funds sold in Canada that hold U.S. stocks. However, they are hedged against any movement of the U.S. dollar against the Canadian dollar. That means that the ETF’s Canadian-dollar value rises and falls solely with the movements of the stocks in the portfolio.

For example, if a stock rises 10% on, say, New York, but also rises a further 5% for Canadian investors due to an increase in the U.S. dollar, a holder of a hedged ETF would only see a 10% rise in the value of that holding in their hedged ETF. At the same time, the reverse is also true: If a stock rises 10% on New York, but falls 5% for Canadian investors due to a decrease in the U.S. dollar, a holder of a hedged ETF would still only see a 10% rise in the value of that holding as part of their hedged ETF.

Note, though, that hedged funds include extra fees to pay for the hedging contracts needed to factor out currency movements. Of course, those costs can rise or fall regardless of currency swings.

Hedging against changes in the U.S. dollar only works in your favour when the value of the U.S. dollar drops in relation to the Canadian currency. If the U.S. dollar rises while your investment is hedged, it reduces any gain you’d otherwise enjoy, or expands a loss. Continue Reading…

Time to repatriate US dollar gains back into loonie?

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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.
The Canadian dollar is under pressure amid weak oil prices and a strengthening U.S. currency.

My latest Financial Post blog is titled It might be time to repatriate your US$ investments and book those currency gains.

Actually, the C$ has strengthened of late, so the timing isn’t as opportune as a few weeks ago. After a long period of strength, the US$ has slightly weakened against various global currencies, even against the loonie.

Even so, we’re still a long way from par and it may make sense to book some of the gains, and if the loonie starts to sag further, repeat the process every time it falls 3 cents or so.

See also the following mid-January Hub blog by Adrian Mastracci: Falling Loonie Strategies.

How the falling loonie affects U.S. equity ETFs

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Depositphotos_40901151_xsAfter the loonie plummeted 2 cents to 81 cents US after yesterday’s surprise interest-rate cut, it seems an apt time to address a common misunderstanding about how the falling Canadian dollar affects US equity ETFs denominated in either country’s currency.

This was nicely tackled a year ago by Dan Bortolotti in his Canadian Couch Potato blog here.

Dan — who is both a consulting editor with MoneySense Magazine as well as an investment adviser with PWL Capital — had been chatting with me about the upcoming MoneySense ETF All-Stars feature in general and about the much-misunderstood topic of currency hedging in particular.

Personally, I believe international securities exposure provides diversification both for stocks or bonds but also currencies. I agree with Certified Financial Planner Fred Kirby (see Getting Help section)  that the first 20% or 30% of foreign currency exposure doesn’t need to be hedged back into your home country (loonie if you’re Canadian, greenback if you’re American). Of course, American investors who bought US stocks then are laughing. Similarly, if a Canadian invested much of their RRSP directly into US stocks or US equity funds denominated in US$ soon after the 2008 financial crisis and didn’t hedge currencies,  they’re probably a happy camper today. Continue Reading…