Currency hedging

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Currency hedging, also known as foreign exchange hedging, refers to the practice of removing the effects of currency fluctuations from the returns obtained by a holding that is valued in a different currency[citation needed].

Foreign equities (US equities, international equities, emerging markets), expose the Canadian investor to currency fluctuations, which may reduce, or add to, yearly returns. This is also true if buying foreign bonds. In the case of foreign equities held over several decades, the dominant opinion on the Financial Wisdom Forum is not to hedge the currency exposure because:

  • over several decades, the currency fluctuations should even out;[1]
  • hedging adds to costs; and
  • for Canadians, hedging may add to the volatility of portfolios.[2]

In contrast, foreign bonds should always be hedged, as unhedged global bonds have 2.5 times the volatility of hedged global bonds.[3]

Currency hedging for foreign stocks

An example

For example, if a Canadian investor purchased a US-based exchange-traded fund (ETF) tracking the S&P500 (and thus valued in US dollars) and the index went up 10% but the Canadian dollar also went up 10% versus the US dollar, the currency change would cancel out the valuation change. A currency-hedged fund would, if the hedging was performed perfectly and at zero cost, cancel out the rise in the Canadian dollar, in this case enhancing the observed return. However, if the Canadian dollar were to fall, a currency-hedged fund would return less money.

Costs for mutual funds and ETFs

Although it is possible for investors to purchase currency-hedged versions of some mutual funds and ETFs, the costs of currency hedging are a matter of some dispute. They have been estimated by adviser Dan Hallett, who recommends currency hedging for those investors who wish to have the currency protection, as 0.4 to 0.5%[4] A tracking-error comparison between the iShares S&P 500 Index Fund (CAD-Hedged) ETF XSP and the S&P500 is shown below.[5] This tracking error, which includes the total of the 0.24% MER, currency hedging costs, and any portfolio mismatching amounts to about 1% per year according to the BlackRocks's data:

Note that prior to November 15, 2005, the investment objective of XSP was to replicate, to the extent possible, the performance of the S&P 500 Index. After November 15, 2005, the investment objective of XSP is to provide long-term capital growth by replicating, to the extent possible, the performance of the S&P 500 Hedged to Canadian Dollars.[6]

XSP Tracking Error to 31-Dec-2011.PNG

Another tracking error chart can be obtained from BigCharts,[7], and is shown below. This chart suggests an error of about 2% per year:
Xsperr.gif

An up-to-date version of the BigCharts graph can be obtained in this link. Although the two graphs disagree significantly in the size of the total tracking error, it is nevertheless clear that currency hedging will add significant costs above the 0.24% MER.

Other arguments against hedging

Increased volatility?

A classic argument in favour or currency hedging it that it lowers volatility, but this is apparently not true for Canadians purchasing foreign stocks. It appears that the reverse is true: hedging increases volatility:[2]

Why isn’t hedging effective in Canada? The Pyramis researchers explain that the US dollar, euro and Swiss franc tend to have negative correlation with the global equity markets. (Recall that when all risky assets plummeted in 2008, the US dollar soared.) Negative correlation is what diversification is all about: any part of your portfolio that goes up when equities go down is a welcome addition, so exposure to these currencies is a benefit, and hedging wipes it out. As the J.P. Morgan authors write: “The hedge will tend to produce profits at the same time that equity markets are advancing, and produce losses when equities are falling.” In other words, it magnifies volatility rather than reducing it.

Currency fluctuations even out over several decades

The following table shows the volatility of the US dollar against the Canadian dollar over periods of one year to 20 years (between 1960 and 2012):[8]

Annualized
standard
deviation (%)
Maximum
annualized
return (%)
Minimum
annualized
return (%)
One year rolling 5.8 29.0 -19.1
5 years rolling 2.9 4.8 -9.5
10 years rolling 2.0 3.7 -4.8
20 years rolling 0.9 1.8 -1.6

Over 20 year periods, currency fluctuations even out, so hedging is not needed for foreign stocks.

Matching non-Canadian dollar expenses

Investors who face significant US-dollar expenses - say, for "snowbirding" in the US - may not wish to hedge so that the currencies of their investments better match the currencies of their expenses.

Currency hedging for foreign bonds

Foreign bonds should always be hedged, unless one wishes to speculate on currency movements. For long-term investors, bonds are supposed to provide stable, low-risk investments, but unhedged global bonds are quite volatile: [3]

On average, currency has made unhedged (global) bonds over 1.5 times as volatile as an investment in Canadian bonds and 2.5 times as volatile as the underlying global bonds with currency exposure hedged away.

Furthermore, hedged foreign bonds are better portfolio diversifiers than their unhedged equivalents: [3]

We can conclude that hedging away the movement of the Canadian dollar allows the properties of the underlying (global) bonds to play the traditional fixed income role of risk reduction. The imperfect correlation of foreign currency with the other stock and bond assets is not enough to mitigate the effects of its higher volatility. In addition, many investors may already have currency exposure in their global equity allocation, meaning that the currency exposure of unhedged bonds isn’t adding anything that a balanced investor doesn’t already have.

See also

References

  1. R. Balakrishnan, Currency Fluctuations and Stock Market Returns, Canadian Capitalist, May 2010, viewed January 5, 2015
  2. 2.0 2.1 Why Currency Hedging Doesn’t Work in Canada, March 2014, viewed December 30, 2014
  3. 3.0 3.1 3.2 Going global with bonds: Considerations for Canadian investors, Vanguard Research (January 2014). Viewed March 1st, 2015
  4. Rob Carrick, The pluses - and minuses - of currency hedging, Globe and Mail, June 6, 2009. Viewed August 15, 2009.
  5. BlackRock Asset Management Canada Limited, Tracking Error Charting Tool, XSP, viewed January 16, 2012.
  6. XSP - iShares S&P 500 Index Fund (CAD-Hedged) Annual MRFP, viewed January 16, 2012
  7. BigCharts, plot of CA:XSP versus S&P500, viewed January 17, 2012
  8. G.G. Dallal, Long-Term Strategic Asset Allocation, CIBC Asset Management, 2013, viewed January 30, 2015

Further reading

External links