At a meeting this week of the OSC steering committee one of the participants was discussing the dilemma of whether or not to hedge a US investment. This theme has been broached previously by another steering committee participant. So I thought it might be a good idea to write about it.
In general terms I understand what hedging means: if you hedge you are removing the impact of currency exchange rates from the overall performance of a foreign investment. In other words, if you wish to ensure that the relative change in value between your own currency and a foreign currency is not going to impact your investment return you should hedge. This way only the relative performance of the underlying security in its own currency will determine your return on investment.
Hedging is not easy to do for retail investors for a single security (e.g., a specific stock or bond). However, there are exchange traded funds (ETFs) that offer hedging for you. These funds manage the futures contracts on currencies for the holdings of the fund on your behalf.
Like many things in investing, whether to hedge or not depends on many factors that only you are best able to answer.
Obviously, the first question is should a Canadian investor own any foreign securities at all? I think the general consensus is “yes” given how small our stock market and economy are in the world and given our relatively easy access to US securities markets. The US market offers a much richer array of investments than those in Canada alone. Of course there are other regions in the world that can help a Canadian investor even further diversify their portfolio if they so desire.
I found a very clearly written piece on the subject of hedging that I will summarize. The links to the source document and examples of hedged products are provided below.
Situations that might lead you to hedge:
- you assume your own currency is going to climb relative to the foreign currency of the investment (e.g., you believe the Canadian dollar is going to rise against the US dollar)
- you don’t really have an assumption about relative currency exchange rate movements (i.e., you don’t have a strong belief in the direction of your own currency vs. the foreign one)
- if the underlying asset tends to move in the same direction as the currency over time hedging may reduce volatility
- your investment timeframe is relatively short and you don’t want currency valuations to affect the performance of your investment
- the cost of hedging is low enough to make it reasonable to do (e.g., US dollar hedges are relatively cheap compared to some other currency hedges)
Situations that might lead you to not hedge:
- you assume your own currency is going to decline in value relative to the foreign currency of the security you own or would like to own
- you have a long investment time horizon and you wish to be exposed to the performance of both the security and the currency
- the investment security tends to perform differently than the underlying currency (i.e., it is not correlated) leading you to favour not hedging as this may provide a source of additional diversification in your portfolio (e.g., the US dollar tends not to gain when the US stock market is gaining)
- not hedging is being used as a further way to diversify holdings (some would argue in the long run hedging is not needed since currencies tend to revert to their mean exchange rates, or balance out in the long haul)
- the cost of hedging is high and affects overall investment performance
For the individual investor, the most practical way to hedge is to buy broad-based ETFs from providers that offer a hedged version of the product. This avoids having to write futures contracts against a currency, a fairly complicated and potentially expensive undertaking.
One other consideration. ETFs that use hedges can be passive or active. The former tends to provide more consistency whereas the latter involves ongoing management. The active approach attempts to add to the return of an investment product by trying to use the currency exchange rate changes as an additional source of income.
In the end, it is up the the individual investor to decide whether or not to hedge. There is no right or wrong answer; it is really about what you are comfortable with. Hopefully these considerations will help with that decision.
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