Should You Currency Hedge

The Canadian dollar is climbing. Since the recent low of January 2016—bottoming out under 68 U.S.D. cents—we've been moving up big time, climbing 18.5% in value. This has reduced portfolio returns as measured in Canadian dollars when holding un-hedged ETFs, or other internationally priced instruments.

Source: Yahoo Finance

In the grand scheme of things this is largely good. When our currency goes up, we are inherently more wealthy relative to other nations. Currency pricing is a great measure of confidence.

If the Loonie is climbing, investor confidence in our economy is also climbing. If it's falling, chances are that our economic prospects are not sizzling. Since we are a commodity country, these swings in the Loonie and investor confidence are often tied to commodity prices.

The Loonie Value Background

We are largely a natural resource driven country. We have vast reserves of oil, natural gas, iron ore, copper, gold, nickel, timber, and all of the other wonderful things that make this world go round. This means our dollar is also correlated to the value of these commodities.

The nice thing about a free-floating dollar is that it tends to take the edge off swings in our economy. A few years ago, oil prices—our major export—tanked. This coincided with a free-fall in the value of our economy in U.S. dollar terms. The decrease in the value of the Loonie lowered costs for commodity producers in international terms. This helped reduce some of the negative effects of the drop in commodity prices.

Likewise, when commodity prices increase the value of the Loonie climbs. This increases costs for producers and prevents the economy from becoming a red-hot inflationary disaster.

But it is important to realize that the oil drop of 2014-2016 was actually part of a larger trend. The U.S. economy has been performing well since 2011 and our dollar slowly has shrunk in value since that time. The Loonie was valued over $1.05 at that peak and declined to under 95 cents before oil collapsed in 2014. The oil impact just pushed the Loonie over the cliff from 93 cents down to 69 cents.

Here's a chart showing the Loonie relative to the U.S. dollar from July 2011 to January 2016:

Source: Yahoo Finance

The recent Loonie recovery shown in the first chart was part of a recovery in oil prices and other commodity values.

Given that we have a more volatile currency, should we protect our portfolio value by using currency-hedged ETFs?

Hedging or No Hedging?

The decision whether or not to use hedged products should be based on your overall portfolio investment strategy.

Many years ago hedged products were soundly ridiculed by the personal finance community. The big argument was—and is still shouted from the rooftops on many blogs—hedging currency is expensive, the cost of hedging reduces returns, and therefore hedging is bad.

It seemingly made things simple. More expensive meant hedging wasn't even considered as a valid option.

Hedging Cost Factor

However, I don't really buy that argument anymore. There is considerable evidence that hedging has gotten much better. Costs are lower, portfolio drag is lower, and strategies executed behind the scenes by the big money managers are better.

This shouldn't be surprising since competition and free markets dictate there should always be improvement and increase in efficiency over time.

Here is a chart comparing a large currency hedged ETF, XSP.TO to its underlying index the S&P 500 from September 2012 to present:

Source: Yahoo Finance

Over the past 5 years, after expenses including hedging costs, the correlation is shockingly close. Just look at those two lines! The cost of managing the ETF with hedging over five whole years reduced price performance by just 20 basis points.

Since cost is becoming a less valid argument for the anti-hedgers, what should drive your decision to hedge or not?

Investment Strategy & Hedging

Given the decreasing cost of currency hedging and assuming you live and spend in Canada, the decision should be determined by your portfolio strategy. This can be broken down into two distinct strategies I entertain on this blog: trend investing or buy-and-hold.

Trend Investing

For trend investors (and I'm one of them), the decision will be based on whatever your trend metrics call for. The Canadian dollar has appreciated relative to most other currencies in the past while, so I am mostly invested in currency-hedged products. Therefore I have been largely protected from the wider impact of the rising Loonie.

As the Loonie appreciates in value, we can buy more stuff with our dollar. This means the value of "stuff" went down in Canadian dollar terms. Likewise, when the value of the Loonie was dropping (from 2011 into 2016), the price of "stuff" went up in Canadian dollar terms. During that period you would have been much better off holding ETFs which are not currency-hedged.

Take this chart of VFV.TO, a large ETF tracking the S&P 500 with no hedging from November 2012 until January 2016:

Source: Yahoo Finance

From ETF inception in November 2012 (when our Loonie was at par with the U.S. dollar) until January 2016, a Canadian investor would have nearly tripled the performance of the S&P 500 when measuring their portfolio in Canadian dollar returns.

For trend investors the answer is simple: you hold currency-hedged ETFs with the Loonie is appreciating and you hold standard ETFs when the Loonie is depreciating. Because trend investing always uses some metric of past performance, you don't need to change anything to help you decide what to hold. The answer is built into the price.

Passive Investing

For a buy-and-hold investor, such as an investor in the Growth Portfolio, the decision is not as easy. There are valid arguments that could be made for each side.

However, I'm generally of the opinion that you should not hedge in a smaller portfolio (under $500,000 in value). The reason is two-fold: 1) it's easier and cheaper to maintain allocations with fewer positions, and 2) we import a lot of what we buy and we're a secondary currency at best so it makes sense for our portfolio to maintain purchasing power in global currencies such as the U.S. dollar and Euro.

To help you manage these swings, maintain your strategy, and keep each position balanced, it's much easier work with fewer holdings. A typical growth portfolio will have 3-to-5 different ETFs at established target allocations. If you introduce hedging for all of your positions, you will still have 3-to-5 different holdings, but now your whole portfolio is tied to the purchasing power of the Loonie only.

Most goods around the world are traded in U.S. dollars—the global reserve currency—so is it really smart for you to focus on the Loonie? I don't think so, but I'm welcome to arguments that it should be.

For larger portfolios, I think there are valid reasons to partially hedge your portfolio with a static portion of your international allocations in currency-hedged products. The reason is three-fold: 1) it only makes economic sense to have more holdings when your portfolio is larger, 2) you are more likely to have experienced large market swings and are likely to be more comfortable with your re-balancing, and 3) a reasonable portion of your spending is made in your home currency so you can allocate within your portfolio with that in mind.

For a growth based portfolio, including currency-hedged products will add 2 ETFs: a currency-hedged U.S. index ETF and a currency-hedged international index ETF. My favoured products for U.S. is XUH.TO and for international is XFH.TO. Both are low-cost ETFs.

In a larger portfolio, each position is still likely to be near, or over 6 figures with the inclusion of two more ETFs. This means that hedging a portion of your portfolio will actually have meaningful impact of the portfolio performance.

By this time in your investing path, it shouldn't matter to you if you are balancing 3 ETFs to your desired allocation or if you are maintaining 7 ETFs at your desired allocation. The process is simple either way: you add money to the low positions and, if necessary, take money from the high positions. You've been there and done it during soaring markets and crashing markets.

A lot of your purchasing is done in Canadian dollars and the price of goods does not always reflect the current value of our currency. There's a lag effect. Remember when our dollar was at par with the U.S. dollar a few years ago? Well, as you probably heard over and over in the news and was moaned by consumer advocacy groups, we still paid more for most things than our southern friends even though we theoretically should not have based on currency value alone.

While there is no exact science that I'm going to dive into today when making a judgement on how much of your positions to hedge, I think it's fair to say you would be silly to currency-hedge all of your international allocation. It would even be aggressive to hedge half as our dollar actually does a decent job of taming big market swings in many cases due to it's commodity bent.

I think it could be logical to hedge either 25% or 33% of your international allocation and then stick with that allocation. It will not do any favours for a passive portfolio if you increase your hedging allocation when you panic at some underperformance during Loonie appreciation and then randomly flip the other way when the Loonie falls.

I like using 25% to 33% because it translates to holding roughly half of your total stock portfolio in Canadian dollars after accounting for Canadian stock allocation.

If you're running the 3-ETF portfolio with a 80/20 stock-to-bond ratio and it's worth $600,000 and you choose to hedge 33% of your international allocations, your portfolio might look like this:

$240,000 (40%) XAW.TO U.S. and International stocks
$60,000 (10%) XUH.TO U.S. hedged stocks
$60,000 (10%) XFH.TO International hedged stocks
$120,000 (20%) XIC.TO Canadian stocks
$120,000 (20%) VSB.TO Canadian short-term bonds

A cautious allocation to currency-hedged ETFs can help take some of the swings out of your portfolio that are caused by currency fluctuations. However, it is important to realize that there's give and take. You will underperform an un-hedged portfolio at times and you will outperform at other times.

I will run a better analysis on partially hedged portfolios in the future to examine the dampening effects in better detail. I believe that in the very long run over full currency cycles the returns will be very similar comparing un-hedged portfolios to partially hedged portfolios.

Given the "newness" of better hedging and low-cost ETF products, it is difficult to get good real-world data to run comparisons with at this time. However, I am sure that in the long run hedging costs will continue to decrease making hedging a better option for those who see value in hedging.

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