Currency hedging could protect your portfolio against volatile loonie

The shrewdest investing move of the past few years was to avoid currency hedging in U.S. and international ETFs and mutual funds.

Now, it's time to consider a partial reversal. Looking ahead for the next few years, a hedge could be an edge in managing the volatile dollar in your portfolio.

Currency hedging quiets the effect that fluctuations in the Canadian dollar against the U.S. and international currencies have on your investment returns. You make what your investments make, minus the cost of owning your mutual fund or exchange-traded fund. Without hedging, a falling dollar adds to your returns in these two categories and a strong dollar does the opposite.

The weakness in the Canadian dollar is perhaps the top story in personal finance and investing right now. The cost of fresh produce, cars, books and other imported goods is rising and so is the cost of buying U.S. dollars for trips south of the border. But the falling dollar has been helpful for investors who have properly diversified portfolios with extensive exposure to the stock markets in the United States and elsewhere in the developed world. In the past three years, the S&P 500 total return index delivered an annualized total return of 15.1 per cent in U.S. dollars. The same index, in Canadian dollars, returned 28.6 per cent, almost double.

The MSCI Europe Australasia Far East (EAFE) index, a benchmark for investing outside North America, made 5.8 per cent last year when measured in the currencies of the index's component countries. In Canadian dollars, it soared 19.5 per cent. Take a bow if you capitalized on the dollar's decline by choosing unhedged international and U.S. funds, and then open your mind to making a minor change of course.

We have to acknowledge upfront that the dollar has room to fall further. Macquarie Capital Markets Canada believes the currency could fall to 59 cents (U.S.) by year's end, a little below the record low of 61.8 cents reached in 2002. Mark Yamada, CEO of PUR Investing, says he uses a grid to assess the dollar that addresses world prices for energy and non-energy items, the spread between Canadian and U.S. interest and inflation rates and the level of U.S. economic growth. The message he's taking from these indicators right now is decidedly bearish for our dollar.

"It can go lower," Mr. Yamada said. "It's frightening to say so, but there's nothing good on the horizon."

But the loonie will rise again, and it's time to start preparing. This shift is as much about your emotional equilibrium as an investor as it is about responding to market developments. With some hedged ETFs or mutual funds in your portfolio, you've prepared for a change in financial conditions and won't feel a sense of powerlessness at being outmanoeuvred by the markets. The more comfortable you are, the less likely you are to start unravelling a soundly built portfolio.

The investing case for adding hedged funds now is based on the idea that the economic conditions in Canada aren't quite as bad as the falling dollar suggests. That's the view at BlackRock Canada, which sells both hedged and unhedged versions of many funds. "At current levels, the currency seems oversold," said Aubrey Basdeo, the firm's head of Canadian fixed income. "If we were making a recommendation, it would be to hedge some [of your holdings] now and look to hedge some later."

Hedging some of your holdings now protects you in case of a near-term rebound in the dollar, while also leaving you with significant unhedged holdings that will do well if we see more dollar weakness. When the dollar has bottomed and is chugging higher on a consistent basis, you can add to your hedged holdings. Consider moving 10 per cent into hedged funds now if you're nervous about the downside for the dollar, and 20 per cent or more if you're not.

Many investors have already started making a move into hedged funds. BlackRock reports net inflows of almost $600-million into its hedged U.S. equity ETFs last year, and a little more than $200-million into non-hedged U.S. funds.

While interest in hedged U.S. ETFs has increased in recent years, investors have shown a preference for unhedged international funds.

This may reflect the fact that you diversify a lot of the risk away in international funds through exposure to many different currencies at once.

The rising level of interest in hedging U.S. exposure obscures the fact there's no consensus in the investing world on how to handle currency risk. Calgary-based Mawer Investment Management has a strong view against hedging and it's based in large part on the idea that currencies are similar to the weather in how complex and difficult to predict they are. "Put a hedge around your house, not around your portfolio," Jim Hall, Mawer's chief investment officer, says in a document the firm has produced on the subject of currency.

PUR Investing's Mr. Yamada uses hedging only for clients who need their money within two years. For the vast majority of portfolios, he subscribes to the academic view of currency having little impact on long-term returns. In fact, the 20-year annualized return for the S&P 500 was 8.3 per cent in Canadian dollars and 8.2 per cent in U.S. dollars.

Funds with currency hedging used to be criticized for having higher fees than non-hedged funds. However, the ETF industry has largely equalized management expense ratios for hedged and unhedged funds. A more relevant issue is tracking error, or the gap between an index-tracking ETF and its underlying stock or bond index. An ETF should underperform an index by the amount of its management expense ratio. But while the most popular TSX-listed S&P 500 ETFs with hedging have management expense rations in the 0.07-per-cent to 0.13-per-cent range, they underperformed the underlying index by about 0.35 of a point last year.

Hedging is an imperfect way to protect against a rising dollar, and some investing pros avoid it. But it's still worth considering for some of your U.S. and international exposure. Plan not just for today's dollar weakness, but also for what comes next.