Investment Workshop 38: Currency Hedging

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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.

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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 Currency Hedging 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.

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.

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

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

American Portfolio

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

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

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

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

Continue onto the next article!

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WORKSHOP TOOLS

How much does it cost to participate in the 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:

1) Questrade

2) Passiv

For Americans:

1) Vanguard

2) Personal Capital

Or, prefer to use a Robo Advisor? Check out Wealthsimple, and get your first $10,000 managed for free!

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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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