# Hedging against a rising loonie (or a falling greenback)



## CanadianCapitalist (Mar 31, 2009)

The S&P 500 is up 35% from its low but the loonie has also risen in value up from 77 cents to 85 cents or 10% over the same time frame. Therefore, a Canadian investors who have not hedged their currency exposure did not enjoy the same upside as an US investor (and to be fair, did not experience the same downside when the markets tanked). 

My rather strong opinion has been that the costs of hedging are certain (many estimates run at 1% per year) and the benefits are debatable. Unhedged investors take currency risk in the hope that it will provide diversification benefits. It seems to be working but it isn't as much fun when it is working against you 

*
The Costs of Currency Hedging*
*The Costs of Currency Hedging: Taxes*
*Revisiting the Tracking Error For Currency-Hedged Funds*

Let's open up this topic for discussion. Many are of the opinion that the strength of the US dollar over the past year was a temporary phenomenon within a secular bear market in the dollar. What if anything are you doing to hedge against a falling dollar (or rising loonie)?


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## refutor (Apr 5, 2009)

it depends on the cost of hedging.

if you look at RBC Mutual Funds for instance, the RBC US Index http://www.rbcam.com/pdf/information/rmfusi.pdf ($C) has a MER of 0.60, while the RBC US Index Currency Neutral http://www.rbcam.com/pdf/information/rmfusr.pdf has a MER of 0.69. is a currency hedge work 0.09%?


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## Sampson (Apr 3, 2009)

Very good question.

For my own portfolio, I've got a very good allocation directly in US dollars - I've always considered earning $CAD to be the best hedge against the falling greenback. To hedge against a weak $CAD, I'll be buying more US equities directly when/if the USD drops.

For my wifes' ETF portfolio, never gave it enough thought so I'm happy you raised the topic. I'm eager to hear what others are doing.


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## CanadianCapitalist (Mar 31, 2009)

The extra MER is *not* the only cost of hedging. It comes in the shape of tracking error and it can be quite horrendous. 

*Currency Neutral Funds Performed Poorly (Again) in 2008*

For instance, XSP underperformance of IVV returns is:

2006 - 1.72%
2007 - 2.29%
2008 - 3.4%

Similarly, TDB904 underperformed TDB952 by:

2006 - 1.1%
2007 - 1.8%
2008 - 1.63%

As you can see, the tracking error is huge as it includes the costs of hedging. Hedging is not free and investors pay for it through tracking errors.


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## Sampson (Apr 3, 2009)

CC - my impression is that you don't believe there is any value in getting the currency hedged options  - but do you do any sort on your own?

Aside from trying to time currency exchanges - is there anything else one could do to hedge against a falling loonie?


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## CanadianCapitalist (Mar 31, 2009)

Sampson said:


> CC - my impression is that you don't believe there is any value in getting the currency hedged options  - but do you do any sort on your own?
> 
> Aside from trying to time currency exchanges - is there anything else one could do to hedge against a falling loonie?


No. I don't do any currency hedging. I expect hedging costs for individual investors to be similar or more than that for currency-neutral funds though I personally don't have any experience in this area.

In any case, I can see the merits of hedging (ignoring the costs for a moment) only for US dollar holdings. Broad international indexes exposed to many currencies probably don't need any hedging at all.


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## mfd (Apr 3, 2009)

Sampson said:


> For my own portfolio, I've got a very good allocation directly in US dollars - I've always considered earning $CAD to be the best hedge against the falling greenback. To hedge against a weak $CAD, I'll be buying more US equities directly when/if the USD drops.



Thats the approach I took. I bought a bunch of American currency when it was at par with the Canadian dollar.


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## Rickson9 (Apr 9, 2009)

We do not hedge our stock portfolios. Our belief is stolen from other investors who have stated that currency fluctuations tend to iron themselves out over decades.

We don't buy U.S. securities based on the relationship between the USD and CND; we buy U.S. securities when we deem them to be cheap.

Approximately 50% of our net worth is in stock.


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## The_Number (Apr 3, 2009)

Interesting info, CC. I was not aware of the tracking error.

If tracking error is what it sounds like (imperfect tracking of the index), can the error occur *in favor* of the investor given the right market environment?

Also does anyone know if it is possible to own IVV in TFSA? If so, how do they calculate the contribution limit in USD?


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## CanadianCapitalist (Mar 31, 2009)

The_Number said:


> Interesting info, CC. I was not aware of the tracking error.
> 
> If tracking error is what it sounds like (imperfect tracking of the index), can the error occur *in favor* of the investor given the right market environment?
> 
> Also does anyone know if it is possible to own IVV in TFSA? If so, how do they calculate the contribution limit in USD?


Tracking error is usually positive because of the MER of the ETF, withholding taxes etc. I doubt if tracking error can ever be favourable to investors for currency-neutral funds because the cost of hedging is said to be around 1%. So, you can expect a tracking error of at least 1%.

You can own IVV in a TFSA. The contribution limit of $5,000 is in CAD. The CAD equivalent of any USD contributions (I don't know if you can contribute USD in cash but either way it doesn't matter) would be considered as your contribution. Your brokerage should be able to provide this value for you. That's how it works for in-kind RRSP contributions.


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## Jon Chevreau (Apr 4, 2009)

I just tweeted on this new Wisdom Tree ETFs that provides currency hedging for Emerging Markets exposure.

http://tinyurl.com/cdum4e


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## CanadianCapitalist (Mar 31, 2009)

Jon's column in the post today:

*Loonie hedge may be wise*

I'm biased but I thought this was the best quote:



> However, Bob Cable of the Mississauga-based Cable Group, does not believe long-term investors need to worry about currency effects.
> 
> "It is just a guess at any time and the cost of doing so adds up."
> 
> ...


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## Rickson9 (Apr 9, 2009)

CanadianCapitalist said:


> However, Bob Cable of the Mississauga-based Cable Group, does not believe long-term investors need to worry about currency effects.
> 
> "It is just a guess at any time and the cost of doing so adds up."
> 
> ...


Agree. 

We don't think about it because over decades it is a non-event.


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## CanadianMoneyBlogger (Apr 4, 2009)

I've been thinking about this issue for a while, and wanted to reply to this thread, but my thoughts turned out to be so long that I posted it on my blog instead:
When to Buy a Currency Hedged Fund

In short, I agree that for the long term buy-and-hold investor, currency fluctuations probably will even out. However, not everyone has a long time-frame left, so it can be an important issue to think about.

In the case of a US index fund, there might be a CAD fund, a USD fund, and a currency-hedged version of the fund. If we say that we don't want to buy the currency-hedged fund because of additional MER and tracking error, then for someone without the luxury of a lot of time, there is still the question of whether to buy the CAD fund or the USD fund.


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## CanadianCapitalist (Mar 31, 2009)

CanadianMoneyBlogger said:


> In short, I agree that for the long term buy-and-hold investor, currency fluctuations probably will even out. However, not everyone has a long time-frame left, so it can be an important issue to think about.


Only long-term investors should be in stocks. If an investor has the time frame to be in equities, they have the time frame to be unhedged.


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## Rickson9 (Apr 9, 2009)

CanadianCapitalist said:


> Only long-term investors should be in stocks. If an investor has the time frame to be in equities, they have the time frame to be in unhedged.


I agree.

If you don't have a time-frame of at least a decade you shouldn't be investing in stocks.


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## CanadianMoneyBlogger (Apr 4, 2009)

Do you recommend that people in the withdrawal stage should not be in equities at all then?


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## CanadianCapitalist (Mar 31, 2009)

CanadianMoneyBlogger said:


> Do you recommend that people in the withdrawal stage should not be in equities at all then?


That's not what I said. I can't see an investor having a long enough horizon for equities but not long enough for being unhedged. If they are willing to accept the risk of being in stocks, they should be able to accept the risk of currency fluctuations. Why would you want one but not the other?


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## Jon Chevreau (Apr 4, 2009)

One piece of feedback I got was that I didn't address more sophisticated currency hedging techniques, like use of futures, which institutions and higher-net-worth individuals might try. I'll take a crack at that one next week in a followup piece. Suggestions as always welcome. 

www.wealthyboomer.ca


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## CanadianMoneyBlogger (Apr 4, 2009)

CanadianCapitalist said:


> If they are willing to accept the risk of being in stocks, they should be able to accept the risk of currency fluctuations. Why would you want one but not the other?


I'm not arguing that in the long run, hedging probably costs more than it's worth and that if you are in long enough that currency fluctuations seem to amount to nil. However, I don't think that accepting the risk of equities means that you should accept the risk of currency fluctuations. With equities, I would accept the risk because I hope that I'm holding a productive asset. The risk of currency fluctuations doesn't really come with the promise of anything productive.

So does the risk come with any reward? If not, why would I accept the risk? If it didn't cost me anything to remove that risk, I wouldn't want to assume the risk. However, I agree that in the real world, it certainly does cost something to hedge, and that on top of that, the hedging error has in practice been pretty horrible.

If I am going to accept that risk, then how can I get some reward for it? Say you believe that in the long run, currency fluctuations amount to zero then maybe it's possible to take advantage of that reversion to the mean by selectively buying the hedged or non-hedged versions of funds based on current exchange rates?


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## CanadianCapitalist (Mar 31, 2009)

CanadianMoneyBlogger said:


> With equities, I would accept the risk because I hope that I'm holding a productive asset. The risk of currency fluctuations doesn't really come with the promise of anything productive.
> 
> So does the risk come with any reward? If not, why would I accept the risk? If it didn't cost me anything to remove that risk, I wouldn't want to assume the risk.


It is true that the long-term expected return from currency fluctuations is zero. But currency fluctuations have low correlation with stock market fluctuations and hence lower the volatility of the overall portfolio. Last year was a great example. US stocks were down but the US dollar was up resulting in better unhedged returns for Canadian investors. 

Now, I understand not all investors will buy this argument. Fair enough. The practical problem with hedging remains. Hedging is quite expensive; so we have a situation where the benefits are debatable but the costs are certain. A 1% to 2% annual hedging expense for a long-term investor is a lot of headwind to overcome for hedging to prove profitable.


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## FinancialJungle (Apr 22, 2009)

1% hedging expense can add up over time. Currency fluctuation aside, a $100k unhedged S&P500 position would grow to $364k over 15 years at 9% annual growth. A hedged position would grow to only $317k. We don't even need a washed currency to get ahead.

Like CanadianMoneyBlogger, I'm also agonizing over the smallish 1% return relative to the amount of currency risks we take on. Time horizon plays a less relevant role for currency than the stock market. Take a look at this chart:

http://content.edgar-online.com/edgar_conv_img/2008/03/13/0001104659-08-017299_G29341BC01I002.JPG

A typical currency cycle is about 16 years; twice as long as a typical stock market cycle. With stocks, if you missed your stop, the next exit is just around the corner. With currencies, well, you might have to wait another 16 years. And the problem is that human lifespan is finite, so we can only accommodate 2 or 3 currency cycles in our working lives. Needless it's much harder to nail the average with fewer flips, and there is a very limited number of opportunities to exit the game, so although currency does wash out _at certain points_ in our lives, it doesn't wash out over time.

I feel like I deserve > 1% return for accepting decades of volatility, but having said that, I haven't found a practical alternative. One possibility is if you're leveraging your portfolio, leverage it in USD at 0.18% interest rate from Interactive Brokers. That way, if USD goes down, so does your loan.

Yet, another option is to borrow USD to buy Canadian Real Return Bonds. 

Having said all the above, it might still be perfectly prudent to own foreign currencies. After all, we consume a lot of imported goods, and some of us do go see the world once a while. Personally, I belong to the no hedge camp.


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## Brad911 (Apr 19, 2009)

For those interested I shared with readers of my site what I used as a *Canadian Currency Hedge Strategy* over the past year.

The big lesson I took away from the experience was that you don't have to make a large investment or take a large position to hedge your entire portfolio. At times simplicity worked best rather than trying to complicate the situation by using a sophisticated strategy. Even considering the tracking error of the ETF I used I still came out ahead in any situation because of the rather small position I needed to take to hedge my currency exposure and protect my purchasing power.

While I used this strategy for a falling CDN currency an investor could easily perform the same task for the opposite direction.


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## CanadianCapitalist (Mar 31, 2009)

Brad: I take it that you are actively managing against currency swings. I have a tough time accepting that this will always work in your favour. You are simply saying that last year your winnings were more than the cost of playing. But what happens when you lose? And, realistically, what are the chances of winning? I'm willing to wager that over time, the winnings just can't overcome the costs.


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## Brad911 (Apr 19, 2009)

CanadianCapitalist said:


> Brad: I take it that you are actively managing against currency swings. I have a tough time accepting that this will always work in your favour. You are simply saying that last year your winnings were more than the cost of playing. But what happens when you lose? And, realistically, what are the chances of winning? I'm willing to wager that over time, the winnings just can't overcome the costs.


I would actually say that I am passively managing against currency swings since I don't take the view that a hedge will necessarily lead to a gain. My objective, as I outlined in the post, was to preserve my purchasing power in the face of an environment that clearly wasn't sustainable. If the hedge ended up costing me a small percentage (<0.25%) of the overall portfolio then the insurance it provided is well worth the effort.

I freely admit that over the long-term I won't have the capability to accurately assess where currency valuations will move, but over the short-term and being in the accumulation phase of my investing horizon I want to protect my purchasing power when converting CDN$ into other currencies (USD in this example). If DTO had depreciated 5-10% I would have had no problem with holding the hedge as I could contribute more CDN$ to USD above parity. But the likelihood of that situation being sustainable was unlikely and I hedged at a minimum an equal amount of my contributions for 2008, 2009 and 2010. If I were to contribute $5K CDN to my RSP in US stocks today I would have maintained my purchasing power exactly as if the CDN$ were still at parity (or close to it). By selling the hedge I've essentially maintained that purchasing power for the short-term.


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## Jon Chevreau (Apr 4, 2009)

Here's my followup column on this subject which appeared in today's FP.

http://www.financialpost.com/opinion/story.html?id=90a73316-aa28-4d5c-b4f5-2017529e9742


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## CanadianCapitalist (Mar 31, 2009)

Brad: Maybe, I'm obtuse but I really don't understand how what you are doing can by any stretch of the imagination be called "passive", which I take to mean as being neutral about the direction and either opting to hedge or leaving unhedged.

Jon: Interesting post. I'm surprised even DFA is jumping on the currency hedging bandwagon. Did they have any explanation on how much hedging is going to cost investors? Do they feel the costs are worth it?

I tend to agree with Norm. The giant multinationals themselves do a lot of hedging to smooth their earnings. Why add a hedge on top of another?

Very few investors worried about hedging in 2003. In fact, everyone wanted foreign content limits relaxed so that they can get that extra boost from foreign stock investing. They were wrong then; I'm not convinced they are right now.


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