Investment Workshop 38: Currency Hedging

Wanderer
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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.

Today I would like to talk about something that a lot of our readers have asked us about: Currency Hedging.

What is Currency Hedging?

Well, as you know, the investment style that allowed us to retire in our 30’s and the one we advocate for in this workshop is to build a passive, Index-hugging portfolio made of low-cost ETFs. Generally, it’s easy to explain. Buy the index, lower fees. Gotcha.

And when you invest in the index of your home country, it’s a no-brainer to pull off. But a slight wrinkle happens when you invest in international indexes because there’s an additional foreign exchange component in it. American Indexes is traded under the hood as American dollars, European Indexes are traded in Euros, and so on. So depending on what currency your portfolio is in, International Indexes will move based on two factors rather than just one: The performance of the Index itself, plus the movement of that currency against your own.

As a result, many International Indexes are offered in two flavours: Normal and Currency Hedged.

So again, what is Currency Hedging?

Basically, Currency Hedging is meant to remove the effects of foreign currency movements from the performance of the ETF. The idea being if an index goes up 5%, and the underlying currency also moves down 3%, a normal ETF would move up 2%, but a currency-hedged ETF should move around 5%. So in this case, currency hedging strips out the negative effects of the currency exchange rate movement.

However, keep in mind that the currency could also move in your favour. For example, if the index goes up 5%, and the currency also goes up 5%, the normal ETF would give you a 5% + 5% = 10% gain, while the currency-hedged ETF would only give you the first 5%, so currency-hedging can go in either direction.

How Does It Work?

I’m not going to get into the nitty-gritty details of currency hedging, but basically the manager of a currency-hedged ETF uses either options or futures contracts designed to move in the opposite direction of the currency it’s betting on. If any of you have ever done options trading (DON’T, by the way), you know that you can buy put and call options to bet on a short term price movement of an underlying stock. A put option, for example, allows you to make money if the stock’s price tanks during the option period.

Same thing, but with currencies.

So by carefully using these options or futures contracts, the portfolio manager can construct a portfolio that more or less counteracts the effect of short-term currency movements.

So Do I Currency Hedge?

Personally, I don’t. And here’s why.

After about a decade of investing, I’ve come with a (relatively) simple way to evaluate whether I wanted to buy a particular investment. Basically, I ask myself “What statement am I making by taking this position?” And then if I fundamentally believe in that statement, I go for it, and if I don’t believe in that statement, I don’t.

For example, the portfolios we build here in this workshop are low-cost Indexing portfolios that distribute our equity weightings across geographies. The statements that this portfolio implies are:

  • Fees are bad
  • Generally, equities will make money over the long term
  • I don’t know which countries will outperform at any given time, so bet on all of them

That’s it, and because I fundamentally believe each statement, I’m OK with owning this portfolio.

However, currency hedging has always struck me as taking a weird position. After all, if a country’s equity market outperforms significantly compared to the rest of the world, generally its currency will do well too. After all, who wants the currency of a country that’s spinning into recession? When the US stock market was cratering in 2008, so did its dollar, and as their economy recovered so did its currency. And if that happens, the forex change would help you, so currency hedging doesn’t make any sense.

In fact, owning currency-hedged ETFs takes the very strange statement of “I believe this country’s equities are good long term performers, but its currency is not.” That’s when owning a currency-hedged ETF benefits you the most. You get the upside of the underlying assets, but not the downside of its plummeting currency.

But again, that’s a very strange situation (Index up, currency down), so since I never fundamentally believed that would happen, I never used currency-hedged ETFs.

So of course that exact weird situation is what actually happened in our portfolio.

What Happened?

Let’s take a look our Workshop portfolio.

Canadian American
Book Value $8000 $8000
Market Value $8065.44 $8424.27
Currency CAD USD
Gain/Loss 0.1% 5.3%

What the Hell? The Canadian portfolio which had been tracking the American portfolio pretty well for the first few months. In fact, as recently as May, both portfolios were returning around 4.5%. In fact, the American one has been performing really clicking hot, netting 5.1% over the 9 months since we started this workshop. Annualized, that’s a little shy of 7%.

But the Canadian one has suddenly plummeted. Why? And more importantly, why am I not worried?

Two reasons:

  • During this time, the TSX went essentially nowhere. In November, the TSX was trading at around 15,100. Today, the TSX is trading at…15,200.
  • The Canadian dollar rocketed upwards

Let’s examine both of these events in isolation, starting with the currency change. In mid July, after weeks of intense speculation, the Bank of Canada increased its key benchmark lending rate, increasing interest rates in this country for the first time in 7 years.

This was a big deal, because even though the US Fed had started raising interest rates last year, the common belief was that Canada wouldn’t because our economy was too weak to sustain higher interest rates. But to everyone’s surprise, our economy starting growing sometime in May, booking a surprisingly strong annualized GDP growth of 3.7%, as reported by, of all people, Fox News.

Canada Growth Rose 3.7% in First Quarter, Tops in G7

~ Fox Business

To everyone’s surprise, Canada became the fasting growing economy in the G7. And to NOBODY’s surprise, the slowest growing economy in the G7 was *snicker* the UK.

The UK has slumped to the bottom of the league table of advanced economies after Canada registered stellar growth in the first three months of the year.

Canada was the final member of the G7 to report its growth figures, which confirmed the UK as officially the joint worst performing member so far this year.

~ The Guardian

Gee…I wonder why.

Ahem, ANYHOO, this caused speculation that our economy was actually doing well, and in July, the Bank of Canada confirmed that outlook by increasing our interest rate. And this made our dollar shoot up. It shot up 7% vs the USD and about 6% vs the Euro.

So what does this have to do with our portfolio? When our home currency got stronger, it made every other foreign currency get weaker by comparison. So when the CAD went up 7% vs the USD, that means the USD got 7% WEAKER against the CAD. And this caused all the International Index ETFs to get hammered. Their underlying assets went up, but their currency went down in EXACTLY the way that currency hedging is supposed to protect you from. But because I didn’t currency hedge, our portfolio got hit.

So What Now?

So am I cursing myself that I didn’t currency hedge our International ETFs on the Canadian portfolio? Not really. Here’s why.

First of all, the USD and the Euro didn’t weaken on their own because there’s something fundamentally wrong with those countries. They weakened because the CAD got stronger. That’s not a bad thing. In fact, denoted in USD, the Canadian portfolio actually went up 6-7% because every Canadian dollar appreciated vs the USD. Right now we’re in Europe getting ready for the UK Chautauqua, and our money’s actually worth a lot more here. So that’s great.

And second, I believe the underperformance of the TSX is a weird, temporary anomaly. Canada’s GDP growth is leading the G7, our dollar’s gone up 7% because people want to invest in this country again, and yet our Index is flat? That doesn’t make any sense.

In fact, if you look at the P/E ratio of the TSX, it’s currently sitting at a paltry 11X. The long-term average is 14X. So we are potentially looking at a pretty sizeable undervaluation here, and for no good reason based on our economy’s performance. So when that corrects, we can expect the TSX to increase by about 25-30%. That move alone, given our 20% weighting on the TSX, would bring our portfolio back in line with the American one at 5-6% up.

Now, I have no idea WHEN that’s going to happen, so don’t for a minute think I’m going to use this information to day-trade. I’m not changing my target allocation based on this, and neither should you. That’s just gambling, and we don’t gamble.

But it is really strange for Canada’s stock market to be valued so low, while our dollar is soaring so high, and our economy has the fastest growing GDP in the G7. That’s why I think the Canadian portfolio’s temporary underperformance is just that. Temporary.

And on that note, it’s time to move onto our regularly scheduled buys.

Canadian Portfolio

As always, we take a current snapshot of our Canadian portfolio with our biweekly contribution added in.

Asset Ticker Unit Price Units Market Value Allocation Target Allocation
Canadian Bonds VAB $25.26 126 $3,182.76 37.16% 40%
Canadian Index VCN $30.86 52 $1,604.72 18.73% 20%
US Index VUN $43.16 37 $1,596.92 18.64% 20%
EAFE Index XEF $29.13 45 $1,310.85 15.30% 16%
Emerging Markets XEC $25.87 13 $336.31 3.93% 4%
Cash $1.00 533.88 $533.88 6.23% 0%

From that, we figure out what we need to do to get back to target…

Asset Ticker Target Allocation Unit Price Current Market Value Target Market Value Current Units Target Units Difference
Canadian Bonds VAB 40% $25.26 $3,182.76 $3,426.18 126 135.6 9.6
Canadian Index VCN 20% $30.86 $1,604.72 $1,713.09 52 55.5 3.5
US Index VUN 20% $43.16 $1,596.92 $1,713.09 37 39.7 2.7
EAFE Index XEF 16% $29.13 $1,310.85 $1,370.47 45 47.0 2.0
Emerging Markets XEC 4% $25.87 $336.31 $342.62 13 13.2 0.2
Cash 0% $1.00 $533.88 $0.00 533.88 0.0 -533.9

And then we figure out what our unit orders are going to be, being careful to stay out of margin.

Asset Ticker Unit Price Action Fractional Units Units Proceeds
Canadian Bonds VAB $25.26 BUY 9.6 10 $252.60
Canadian Index VCN $30.86 BUY 3.5 3 $92.58
US Index VUN $43.16 BUY 2.7 3 $129.48
EAFE Index XEF $29.13 BUY 2.0 2 $58.26
Emerging Markets XEC $25.87 BUY 0.2 0 $0.00
Total $532.92

American Portfolio

And on our American side, we start by taking a snapshot of our portfolio with the cash added in.

Asset Ticker Unit Price Units Market Value Allocation Target Allocation
Bonds BND $81.96 40 $3,278.40 36.74% 40%
US Index VTI $126.66 20 $2,533.20 28.39% 30%
International Index VEU $52.08 50 $2,604.00 29.18% 30%
Cash $1.00 508.67 $508.67 5.70% 0%

We figure out what we have to do to bring out portfolio back on target…

Asset Ticker Target Allocation Unit Price Current Market Value Target Market Value Current Units Target Units Difference
Bonds BND 40% $81.96 $3,278.40 $3,569.71 40 43.6 3.6
US Index VTI 30% $126.66 $2,533.20 $2,677.28 20 21.1 1.1
International Index VEU 30% $52.08 $2,604.00 $2,677.28 50 51.4 1.4
Cash 0% $1.00 $508.67 $0.00 508.67 0.0 -508.7

And finally, we decide on our unit buy orders being careful not to go into margin.

Asset Ticker Unit Price Action Fractional Units Units Proceeds
Bonds BND $81.96 BUY 3.6 4 $327.84
US Index VTI $126.66 BUY 1.1 1 $126.66
International Index VEU $52.08 BUY 1.4 1 $52.08
Total $506.58

And we’re done! Thanks everybody, and see you next week!

WORKSHOP TOOLS:


How much does it cost to participate in this investment workshop? NOTHING. Because that's how we roll. All we ask is that you sign-up using the following affiliate links to keep it free forever:


For Canadians:
Questrade

For Americans:
TD Ameritrade
Personal Capital


Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.

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24 thoughts on “Investment Workshop 38: Currency Hedging”

    1. Again, the USD didn’t fall. The CAD went up. The Dow DID hit record highs, and Americans trading in USD DID see the bump he’s referring to.

      It remains to be seen whether any of it was a consequence of his actions though.

  1. Very interesting post on Currency Hedging. When I started following this workshop, I made the decision to take the emotion out of each buy and trust in the long term trend as per all the posts the two of you have written about. Now, when I see the stock down, I get a little excited; Weird to say I know.
    I was wondering if you could go into Limits and other buying options on Questrade. When does it make sense to choose other options on the buy drop menu besides Market?

    1. I played around the Limit option while buying and 50% success obtained. I used to quote few cents less that the current asking price and place the limit order. in few hours/minutes, those orders are executed.
      I started enjoying these limit orders as I am not in rush of my trades and slipping a day or two of our scheduled buys not going to make much difference though.

      1. Eh, those are kinda fun when they work out, but in the early part of 2012 I kept running into this issue where I would set the limits just a few bps below market and then watching the damn price run away while I was just caught there flat-footed holding an empty bag. That got old fast, so now I just stick with market orders.

        1. Limit orders can still be good on the off chance you get a really unpredictable price. I generally use limit orders but put them at least higher than the bid price and often close to the ask price so that they don’t stay open for too long.

          For small buys it’s probably not a big deal, but for larger buys it can save a few dollars.

          1. Yes, for bigger volumne, few cents makes a difference for sure and its kind of fun to play as well 🙂
            On the side note, between Bid and Ask there is only a cent or two difference though and immediately it gets filled.
            I am waiting for VAB to touch back 25.20, but as W said, went empty handed last two days…probably will have to buy at market price today 🙁

  2. Thanks for great article about currency hedging. It really helps me to understand what’s going on with my portfolio.
    Although it might be a stupid question but how would you guys make a correct asset allocation when you use US equity that is trade in Nasdaq such as VTI in RRSP? Because I’m having hard time to calculate the currency and see what percentage of it from my total assets.

    1. The entire American portfolio that holds VTI is denominated in USD, so I’m just pretending I’m an American for the benefit of our American readers.

  3. So, Options, why are you against trading options as part of your Portfolio? If done with care, they can be very powerful and multiply your earnings. Just curious.

      1. There are sort of other uses for options, depending on what you’re doing, that will seem a lot less like gambling – covered calls, for example. Admitting first that I’m not using ETFs but rather actual stocks, I typically sell any stock holding when it hits a certain percentage gain, as I can always go find something else to buy with the money. You can collect premiums on the options in the mean time and if it happens to pass the call threshold it gets sold (which is what I would have been doing anyway).

  4. I am from Denmark and have invested in Vanguard Total World Stock (VT) because it captures the global stock market in one ETF. Thus, I am not particular happy about the depriciating USD against EUR/DKK.

    The last couple of months the USD is down more than the ETF (in USD) is up so I have actually incurred unrealized losses in my portfolio.

    However, on the other hand it has suddenly become a lot cheaper for me to purchase new ETF-shares because the dollar has become cheaper, so maybe the falling USD is really not such a bad thing right now when I am accumulating shares?

    1. Hmm so you’re converting all your savings into USD? I think you might be taking on more forex risk than you need to. Is there no euro equivalent ETF available to you?

      1. But even though you buy a global index ETF listed in Euros (like the iShares EUNL which tracks the MSCI World Index) about half of the underlying equities would still be in USD?

        For example: Vanguard total global stock market (VT) is up 13.21% YTD but that gain is almost offset by the weakening of the USD (down 12.28% YTD). On the other hand the iShares EUNL has only gained 0.29% YTD even though it basically tracks the same index as VT.

        So really not much of a difference if you buy a global index ETF in USD or EUR because the US stock market is weighing around 50% of the total global stock market.

  5. I used to be completely unhedged with US equities and the Trump bump really helped with that (surging stocks AND surging USD), but about a month ago I altered the stocks to be half hedged and half unhedged as the CAD has been rallying incredibly and my US equity holdings were actually declining as a result, even though the S&P has been doing well.

    As you explained, currencies often move with stocks and I’m not a huge fan of the volatility this provides. A 20% loss becoming a 40% loss would be devastating, and vice versa would make you feel like a God. Hedging removes emotions a little bit more and focuses simply on the stock market. This is surely a good thing in the long run for preventing emotional trading.

    I do think the USD is a strong currency though, hence I kept some exposure to it.

    1. I initially had this discomfort as the CAD started climbing, but after doing some math felt much better about it. And after a while, it started to become less emotional again. Nothing like exposing yourself to a bit of pain for a while to calm the nerves 🙂

      1. True, but with that being said I do think there is an argument for reducing exposure to USD when you’re Canadian right now and especially 3 months ago when the CAD was at its lowest level in a long long time. The long-term trend says the Canadian dollar should be valued at around $0.81 USD. Buying USD stocks when the CAD was worth close to $0.70 doesn’t make much sense long-term. Now it’s around $0.80 so we’re around about the average now.

        Here’s to hoping the CAD keeps rising to close to 1:1 and we can all get a bargain in US stocks 🙂

        1. There is such an argument, for sure. Personally I just keep an eye to diversification (including geographic) and don’t worry too much about exactly keeping score – if I’m aiming to diversify it’ll balance itself out over time, which is the key factor. I’m apt to hold a bit more in USD though because quite a lot of my compensation is already in USD and I don’t really feel the need to convert it to CAD.

          1. Aha, well that is very different then. If you’re paid in USD though I’d have damn sure converted it to CAD over the past year or so if I were you!

            1. I’m only 40% paid in USD and all of that is stock. 🙂 Between remaining bonus + salary and tax return via RRSP contribution, I probably get about as much CAD to save as well, so I retain a lot of USD in the end.

              The other thing to bear in mind – when out of country, as long as it’s the CAD appreciating against the USD, we’re no worse off spending-wise, although obviously we get more for our money when spending CAD than we used to.

  6. Great post as usual, Wanderer. Readers who are interested in additional information on why a hedged index portfolio doesn’t reduce volatility in Canada might check out this link from Canadian Couch Potato (http://canadiancouchpotato.com/2014/03/06/why-currency-hedging-doesnt-work-in-canada/).

    An interesting point noted in the article: in some developed countries, currency hedging reduces volatility once a portfolio’s exposure to foreign currency is above 25% (US, UK, Japan, Germany, Switzerland as examples). This rule doesn’t hold true in Canada (nor Australia) since our dollar is so closely linked to oil and other commodity prices. CAD is sometimes called a “petro-currency” for this reason. Exposure to foreign currencies — especially US dollar, euro and Swiss franc — increases the diversity of a Canadian’s portfolio since these currencies are negatively correlated with global equity markets. Reducing the currency exposure through hedging reduces diversity and increases volatility.

    Another interesting point is that Canada Pension Plan sees “no compelling reason to hedge equity-related currency exposure,” since doing so would “unduly tie Fund returns to the price of oil and other commodities as they drive the foreign exchange value of the Canadian dollar.” I will trust the judgement of a fund which manages over $300 billion in assets. No hedging for me.

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