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. I’m Ben Felix, Associate Portfolio Manager
at 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 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 universal 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. With that being said.. 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. My name is Ben Felix of PWL Capital and this
is Common Sense Investing. I’ll be talking about a lot more common
sense investing topics in this series, so subscribe and click the bell for updates. 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.