Currency Hedging & Your Portfolio

When it comes to investing in international markets, the complexities of currency fluctuations can pose significant challenges. For Canadian investors, venturing beyond local borders offers opportunities for diversification, but it also introduces foreign exchange (FX) risk. This article explores the implications of currency hedging¹, the importance of understanding FX correlations, and how to navigate these considerations effectively using ETFs.

Investing outside of Canada can enhance a portfolio by providing access to a broader range of assets and markets. This diversification is crucial, as different regions often exhibit varying performance, influenced by unique economic conditions. However, with these opportunities comes the inherent risk associated with currency movements. Since international assets are priced in foreign currencies, fluctuations can meaningfully affect returns when converted back into Canadian dollars (CAD). 

For instance, consider periods when the CAD strengthens against the U.S. dollar (USD). In such times, while an index like the S&P 500 may show healthy returns in USD, the translated returns in CAD could be significantly lower if the currency exchange rate shifts unfavourably. Conversely, during times when the CAD weakens, Canadian investors may experience enhanced returns when foreign investments are unhedged, as the depreciation of CAD can amplify gains. ETFs provide an efficient way to access international markets. You can trade them during regular market hours (even if the international market isn’t open), and you have the flexibility to choose between hedged and unhedged options.

Currency risk can be a double-edged sword. On one hand, if an investor believes that a foreign currency, such as the USD, will appreciate against the CAD, allocating to an unhedged ETF can translate into additional returns. On the other hand, if an investor anticipates that the foreign currency will weaken, looking to a hedged ETF becomes a prudent strategy to protect against potential losses. 

A key factor in deciding whether to hedge is the correlation between the underlying investments and the currency. For instance, if the performance of a currency is negatively correlated with the underlying assets, holding an unhedged position can actually provide a diversification benefit, potentially reducing overall portfolio volatility. On the contrary, if the currency tends to move in tandem with the assets, hedging may be necessary to mitigate added volatility.

Many investors adopt a blended approach, utilizing both hedged and unhedged investments to capitalize on potential currency movements while managing risk. A common strategy involves maintaining a 50/50 split between hedged and unhedged positions in an ETF, allowing for flexibility and responsiveness to changing market conditions.

Ultimately, the decision of whether to hedge is nuanced and should be tailored to the investor's individual circumstances, market outlook, and risk tolerance. By understanding the interplay between foreign investments and currency risk, investors can make informed choices that align with their overall investment strategy. 

In the intricate dance of international investing, currency risk plays a pivotal role. For Canadian investors, navigating this landscape requires a thoughtful approach to currency hedging using ETFs. By assessing market conditions, understanding correlations, and considering the potential impact of currency fluctuations on returns, investors can develop a strategy using hedged and unhedged ETFs that not only mitigates risk but also enhances overall portfolio performance.