This video is in response to a question fromabe on LinkedIN.
Abe wanted to know if he should hedge theforeign currency exposure of his equities when the Canadian dollar is weak.
There is no question that investing globallyis beneficial.
Diversification is the best way to increaseyour expected returns while decreasing your expected volatility.
Diversification is, after all, known as theonly free lunch in investing.
When you decide to own assets all over theworld, you are not just getting exposure to foreign companies, but also to foreign currencies.
I’m Ben Felix, Associate Portfolio Managerat PWL Capital.
In this episode of Common Sense Investing,I’m going to help you decide if you should currency hedge your portfolio.
If you own an investment in a country otherthan Canada you are exposed to both the fluctuations of the price of the asset in its home currency,and the fluctuations in the currency that the asset is priced in.
For example, if a Canadian investor owns anS&P 500 index fund giving them exposure to 500 US stocks, and the S&P 500 is up 10%,but the US dollar is down 10% relative to the Canadian dollar, then the Canadian investorwill have a return of 0%.
To avoid the impact of currency fluctuations,some investors choose to hedge their currency exposure.
If our Canadian investor had purchased a hedgedindex fund, eliminating their currency exposure, they would have captured the full 10% returnof the S&P 500 index without being dragged down by the falling US dollar.
Before I continue, I want to be clear thatI am talking about adding a long-term hedge to your portfolio.
Trying to hedge tactically, by predictingcurrency movements, is a form of active management which you would expect to increase your risks,costs, and taxes.
Now, on with the discussion.
Multiple research papers have concluded thatthe effects of currency hedging on portfolio returns are ambiguous.
In other words, with hedging sometimes youwill win, sometimes you will lose, but there is no evidence of a universal right answer, unless youcan predict future currency fluctuations.
With no clear evidence, and an inability topredict the future, the currency hedging decision stumps many investors.
The demand for hedging tends to rise and fallwith the volatility of the investor's home currency.
If the Canadian dollar strengthens, investmentreturns for Canadian investors who own foreign equities will fall, which might make the investorswish they had hedged their currency exposure.
While it may seem obvious that a hedge wouldhave made sense after the fact, hedging at the right time is impossible to do consistently.
In a 2016 essay titled Long-Term Asset Returns,Dimson, Marsh, and Staunton showed that between 1900 and 2015 real exchange rates globallywere quite volatile, but did not appear to exhibit a long-term upward or downward trend.
In other words, over the last 115 years currencieshave jumped around a lot in relative value, but you would not have been any better offwith exposure to one currency over another.
This was similarly demonstrated in Meir Statman’s2004 study of US hedged and unhedged portfolios over the 16 year period from 1988 to 2003.
The study concluded that the realized riskand return of the hedged and unhedged portfolios were nearly identical.
If there is no expected benefit to hedgingyour foreign equities in terms of higher returns or lower risk, why would you hedge at all? It is always important to remember why weare investing.
Most people are investing to fund future consumption,and most Canadians will consume in mostly Canadian dollars.
Hedging against a portion of currency fluctuationsmight help investors capture the equity premium globally while limiting the risks to consumptionin their home currency.
With that being said.
It is typically not a good idea to hedge allof your currency exposure because because currency does offer a diversification benefit.
Well, it seems like we’re back to squareone, trying to decide whether we should hedge or not.
There is no evidence either way.
You would not expect a difference in long-termrisk or return from hedging.
Currency hedging at least a portion of yourequity exposure has the benefit of keeping some of your returns in the same currencyas your consumption, but too much hedging removes the diversification benefit that currencyhas to offer.
In the absence of an obvious answer, I thinkit makes sense to take a common sense approach.
If you’re going to hedge, don’t hedgeall of your currency exposure – I wouldn’t hedge more than half of the equity portionof your portfolio.
If you don’t want to hedge, that is ok too.
Remember that there is no evidence in eitherdirection.
Whatever you choose to do, understand thatthere will be times when you wish that you had done something different.
If the Canadian dollar rises, you might wishthat you had hedged.
If it falls, you might wish you were not hedged.
At those times, the worst thing that you cando is change what you are doing.
The best thing that you can do is pick a hedgingstrategy and stick with it through good times and bad.
Join me in my next video where I will tellyou if you should invest in high yield bonds.
My name is Ben Felix of PWL Capital and thisis Common Sense Investing.
I’ll be talking about a lot more commonsense investing topics in this series, so subscribe and click the bell for updates.
I want these videos to help you to make smarterinvestment decisions, so feel free to send me any topics that you would like me to cover.