Investment Workshop 20: Currency Hedging

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 are 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 makes 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) that currency hedging would benefit. Plus, I’m also a big believer in keeping investments as simple as possible, and currency hedging adds complexity and fees, without providing a clear benefit.

To Hedge or Not To Hedge

If you’re thinking “But If I don’t currency hedge, does that mean I need to trade in different currencies?”

The answer is no.

What currency a fund trades in is separate from whether it implements currency hedging. Funds can, for example, track the US index, be traded in CAD, and be either CAD-hedged or not. If you don’t want the added complexity of managing different currencies, make sure all the funds you choose are traded in one currency. And if you want to make sure a fund is (or isn’t) currency hedged, it will usually tell you in the name of the fund.

For example, the iShares fund XUS is an S&P 500 index fund that isn’t currency hedged, but a similar fund from the same company XSP tracks the same index with currency hedging, which you can tell from the fund’s name iShares Core S&P 500 Index ETF (CAD-Hedged).

For the record, none of the funds we use in the workshop are currency hedged. If you want currency hedging in your portfolio for whatever reason, you’ll have to swap out the funds for currency-hedged versions.

Onto the next section!

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1) Questrade

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1) Vanguard

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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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