In this article I would like to explore whether it is necessary, or profitable to hedge currency exposure to currency fluctuation.
Brandes Institute Study
- Brandes institute analyzed 34 years of data and the potential implications for currency hedging programs. Their main assumption was that an investor is exposed to an unhedged international equity portfolio (although they do not specifically define what that portfolio is)
- They demonstrated that hedging currency exposure may have large impact to a portfolio in the currency of their country
- High Short-Term Volatility: For example, if a Canadian Investor Hedged exposure to foreign currencies the potential return of a 1 year hedge can range between negative 15%-20% to positive 15%-20% percent. This is a 40% range!
- However, I don’t believe it is correct to look at a hedged portfolio in terms of profit vs. loss. I believe investors should look at hedged portfolios as protected against unfavorable currency fluctuations. In some cases, one will forego foreign currency returns. In others, they will save their portfolios from a currency decline.
CAD/USD Pair Example:
This is a good start but I want to get more specific. So let’s go into the weeds.
I am an investor residing in Canada. I am really interested investing in SP500, and would like to see how the USD/CAD foreign exchange rate fluctuates and impacts my investment into SP500. Why SP500? In the last 15 years, for example, SP500 has significantly outpeformed TSX60 (9.6% for SP500 vs. 6.01% for TSX60 – Source: MorningStar Canada). If an investor’s returns are unhedged, then there could be a significant impact on portfolio performance.
Returns below are total returns for a Canadian Investor who purchased USD Dollars for 1, 5, or 10 Year periods. Full data can be downloaded here.
|Category||1 Year Return (Rolling)||5 Year Return (Rolling)||10 Year Return (Rolling)||20 Year Rolling Return|
So what does this all mean?
- If I invested into a USD dollar asset on any random year (based on 31 years in this database), by return for one year would be fall between -11% and 16%.
- If I invested into a USD dollar for 10 years, my average return would be approx -1%, however, my total return for 10 years would fluctuate between -36% and + 35%.
Does it make sense to hedge USD currency exposure?
The answer will depend on a few factors.
- Unpredictability: First of all can an investor predict long-term returns on USD currency? I am personally incapable of it. Therefore, I choose to hedge my portfolio. I don’t want to speculate on USD currency fluctuation because I cannot predict the outcome.
- Liability based consideration: Individual circumstances are different. Some investors may save for a USD dollar denominated purchase, and may need to invest in USD dollars directly. Potentially in small purchases, or when they believe the USD dollar value is attractive (i.e. based on PPP model or another measure)
What about currency meltdowns?
- There are multiple cases of hyperinflation that may destroy an investor’s currency. However, these events can be highly uncertain.
- If a Canadian Dollar or another currency experiences a significant decline due to hyperinflation or another reason, then it is better to be unhedged compared to another currency that experiences no inflation (i.e. USD dollar).
- In terms of USD, as of 2021, both central banks are printing enormous amounts of money and monetary and fiscal policies are consistent
My personal situation
- One day I do plan to become a snowbird and spend 3-6 months in Florida (or a country like Ecuador where currency is pegged to USD dollar)
- However, I would not be happy seeing my portfolio fluctuate 30% + on a 10 year period
Personal Decision: Hedge all or most USD currency exposure. Do not hedge Gold exposure as gold is quoted in all currencies and is considered a currency in itself by many investors around the world.
Investor Circumstances: once again, every person’s circumstances are different. If in doubt, please consult an investment professional.
Appendix: CAD USD Dollar Chart (1957-2021)