Including assets traded in foreign currencies (often through exchange-traded funds, or ETFs), can be a great way to diversify an investment portfolio – but it also exposes investors to “currency risk.”
Currency risk refers to the risk that the value of an investment will decrease due to changes in the exchange rate between the domestic currency and the foreign currency. For a Canadian investor, the appreciation or depreciation of foreign currencies against the Canadian dollar can have a considerable impact on the overall return of their foreign investments.
This article delves into the concept of currency hedging and its implications for investors, while also highlighting important factors to consider when deciding whether to hedge or not.
Exploring Currency Hedging
Currency hedging can be employed as a risk management tool to offset the effects of currency fluctuations on foreign investments. However, navigating the complexities of currency hedging can be challenging. This is where currency-hedged ETFs come into play, offering a convenient investment option for those seeking to limit currency risk.
Understanding Currency-Hedged ETFs
Currency-hedged ETFs are investment funds designed to minimize the influence of foreign exchange rate fluctuations on investment returns. By using sophisticated hedging strategies, these ETFs provide investors with a return that closely aligns with the performance of the underlying assets in the local market, while minimizing the impact of currency volatility. They serve as a practical solution for investors seeking to reduce most of the downside risk of having foreign currency exposure in their portfolios.
Considerations for Hedging Decisions
When choosing between hedged and non-hedged currency ETFs, investors should carefully assess the following four factors:
- Investment Outlook: Evaluate the anticipated direction of currency movements and assess the impact of hedging on potential gains or losses. Hedging reduces the risk of unfavourable currency fluctuations and limits potential gains. Hedged ETFs offer stability by eliminating or limiting the impact of currency fluctuations.
- Time Horizon: Determine your investment time horizon and analyze the expected level of currency volatility over that period to determine the need for hedging. Investors with shorter time horizons may benefit from hedged ETFs to mitigate currency volatility, while investors with longer horizons may see reduced value in hedging
- Currency Pair: Consider the correlation between the domestic currency and the foreign currency investment, as well as the potential diversification benefits associated with unhedged positions. Currencies that exhibit a negative correlation with equity markets offer investors an extra layer of diversification, and choosing an unhedged position can potentially lower portfolio volatility. Conversely, for currencies that tend to be positively correlated to equities, the currency can introduce additional volatility, which can be reduced by adopting a hedged position.
- Cost of Hedging: Take into account the expenses associated with currency hedging, including management fees, tracking error and trading costs, to understand the impact on overall investment returns. Hedging is an additional trading expense, which can decrease the returns you receive. For instance, consider one of the major Canadian ETFs designed to closely replicate the performance of the S&P 500 index. As of June 30th, 2023, the hedged version of this ETF delivered a 10-year annualized return of 11.51%, whereas the unhedged version returned 15.03% over the same period, not all of which may be attributed to hedging costs.
By understanding the concept of currency hedging and carefully evaluating the factors mentioned above, investors can make informed decisions that align with their financial objectives and situation when it comes to choosing between hedged and non-hedged currency ETFs.