Should You Currency Hedge Your Portfolio?

This video is in response to a question from Abe on LinkedIN. Abe wanted to know if he should hedge the foreign currency exposure of his equities when the Canadian dollar is weak.

There is no question that investing globally is beneficial. Diversification is the best way to increase your expected returns while decreasing your expected volatility. Diversification is, after all, known as the only free lunch in investing. When you decide to own assets all over the world, you are not just getting exposure to foreign companies, but also to foreign currencies.

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 other than 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 an S&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 investor will 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 hedged index fund, eliminating their currency exposure, they would have captured the full 10% return of the S&P 500 index without being dragged down by the falling US dollar.

Before I continue, I want to be clear that I am talking about adding a long-term hedge to your portfolio. Trying to hedge tactically, by predicting currency 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 that the effects of currency hedging on portfolio returns are ambiguous. In other words, with hedging sometimes you will win, sometimes you will lose, but there is no evidence of a right answer, unless you can predict future currency fluctuations. With no clear evidence, and an inability to predict the future, the currency hedging decision stumps many investors.

The demand for hedging tends to rise and fall with the volatility of the investor’s home currency. If the Canadian dollar strengthens, investment returns for Canadian investors who own foreign equities will fall, which might make the investors wish they had hedged their currency exposure. While it may seem obvious that a hedge would have 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 globally were quite volatile, but did not appear to exhibit a long-term upward or downward trend. In other words, over the last 115 years currencies have jumped around a lot in relative value, but you would not have been any better off with exposure to one currency over another. This was similarly demonstrated in Meir Statman’s 2004 study of US hedged and unhedged portfolios over the 16 year period from 1988 to 2003. The study concluded that the realized risk and return of the hedged and unhedged portfolios were nearly identical.

If there is no expected benefit to hedging your foreign equities in terms of higher returns or lower risk, why would you hedge at all?

It is always important to remember why we are investing.

Most people are investing to fund future consumption, and most Canadians will consume in mostly Canadian dollars. Hedging against a portion of currency fluctuations might help investors capture the equity premium globally while limiting the risks to consumption in their home currency. It is typically not a good idea to hedge all of your currency exposure because because currency does offer a diversification benefit.

Well, it seems like we’re back to square one, trying to decide whether we should hedge or not. There is no evidence either way. You would not expect a difference in long-term risk or return from hedging. Currency hedging at least a portion of your equity exposure has the benefit of keeping some of your returns in the same currency as your consumption, but too much hedging removes the diversification benefit that currency has to offer.

In the absence of an obvious answer, I think it makes sense to take a common sense approach. If you’re going to hedge, don’t hedge all of your currency exposure – I wouldn’t hedge more than half of the equity portion of your portfolio. If you don’t want to hedge, that is ok too. Remember that there is no evidence in either direction.

Whatever you choose to do, understand that there will be times when you wish that you had done something different. If the Canadian dollar rises, you might wish that you had hedged. If it falls, you might wish you were not hedged. At those times, the worst thing that you can do is change what you are doing. The best thing that you can do is pick a hedging strategy and stick with it through good times and bad.

Join me in my next video where I will tell you if you should invest in high yield bonds.

I want these videos to help you to make smarter investment decisions, so feel free to send me any topics that you would like me to cover.

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Dimensional Fund Advisors, an evidence-based asset management firm, hedges about 50% of the foreign currency exposure in their global model portfolios. The Canadian Couch Potato model portfolios do not include any hedging at all. These are two excellent sources of investment thinking, with two different answers to the hedging question. In the absence of an obvious answer, I think it makes sense to take a common sense approach. If you’re going to hedge, don’t hedge all of your currency exposure – I wouldn’t hedge more than half of the equity portion of your portfolio. If you don’t want to hedge, that is ok too. Remember that there is no evidence in either direction.