Foreign Currency Hedging: Easy Using ETFs, But Should You?

Editorial Note: When I hear the word hedge, I think of radiology reports. However, it applies to investing too. This post provides good background information and data about whether to currency-hedge or not. ETFs make this relatively simple and low-cost. However, the primary question is whether to do it or not. I get asked about this whenever the US dollar is strong or weak. Or some political or economic narratives are causing people to have strong opinions about where the $CAD is heading. You need to look no further than the recent US election for an example. Is hedging against foreign currency volatility worth considering? Or is it noise? What benefit or cost does currency hedging to $CAD bring to a portfolio? Explore those questions below.

This is a paid sponsor post. You will see relatively few of these on The Loonie Doctor because my mission is the priority of this site. Sponsored posts must align with that and the sponsor provides a service or product that I would use myself or recommend to a family member. One that I like. I retain editorial control, and the articles are written to be educational as the primary objective. It is a win-win because you get deep content written by industry experts, but vetted by me. You can read more about why I decided to collaborate with BMO ETFs as a sponsor, but I think you’ll get it after reading this post.

To Hedge FX Risk, or Not To Hedge?

By: Erin Allen, VP, BMO ETFs, Online Distribution

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That is the question.

Admittedly, using a spin on a famous Shakespeare quote to start a note on currency hedging is verging on trite. Nevertheless, if Hamlet was running a portfolio of overseas assets, his primary concern would have to be the “slings and arrows” of currency markets—which are notoriously difficult to call but can meaningfully impact portfolio returns.

For Canadian investors, looking abroad provides several benefits. The most important is diversification, whether it’s through access to other regions that are less correlated with Canadian markets or to other products that aren’t available domestically. However, investing abroad also means taking on foreign exchange risk given that international assets are priced in currencies other than the Canadian dollar (CAD).

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A Currency Boon

For illustrative purposes, consider this chart which shows the total return for the S&P 500 in U.S. dollars (USD) and in CAD terms for Q1 of 2024.

In USD terms, the index was up 10.6% over that time frame, but since that period also corresponded to weakness in the CAD relative to the USD (or USD/CAD moved higher) the index outperformed in CAD terms (up 13.3%).

That means that Canadian investors would have fared much better leaving their USD exposure unhedged ex ante.

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A Currency Bane

Now let’s look at an alternative period in which the CAD strengthened against the USD. Chart 2 shows a comparison of the total return for the S&P 500 from April 2020 to April 2021 (in which USD/CAD was lower by over 11%).

During that period, the total return index outperformed in USD terms by close to 20%.

In this scenario, an investor who had hedged their FX risk would have been in the optimal position.

Considering Currency Risk

As the above examples show, currency risk is a key consideration for any investor who wants to look beyond Canada for diversification. That risk from currency fluctuation can cut both ways, which amplifies the importance of hedging decisions. In our minds, the decision to hedge FX risk (including the degree to which foreign exposure is hedged) comes down to the following:

1. An investor’s view of the underlying currency pair
2. Whether the currency pair is positively or negatively correlated with the underlying asset

Currency Markets are Fickle

Taking a view on the underlying currency pair is easy to do—but difficult to capitalize on.

Indeed, foreign exchange markets are notoriously fickle. One reason why is the relationship between predictive factors and currency pairs is rarely stationary. Let’s examine a couple of commonly cited relationships.

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Currency Exchange & Central Bank Divergence

For instance, a lot of market participants tend to use front-end (2-year) yield spreads as a proxy for central bank divergence in the spot FX market. The chart below shows the current correlation between those spreads and the different CAD crosses, and as expected, the relationship isn’t consistent from a cross-sectional perspective.

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Canadian Dollars as an Oil Currency

We can also see this by looking closer at the relationship between a factor and a currency pair over time. The Chart below shows the rolling 100-day correlation between USD/CAD and the price of oil (proxied by the prompt WTI contract) going back ten years. Note how frequently the strength of the correlation (as well as the sign) changes over time.

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“Pricing” Currencies

Additionally, there is no bulletproof way to come up with a cogent ‘fair value’ model for a currency pair. This is not only because the nature of the relationship with factors is inconsistent, but also because (unlike stocks or bonds) there is no future cash flow to discount when you go long or short a currency pair. The changing nature of the macro environment, alongside the sheer size and depth of the FX market, makes it near impossible to have an edge or generate alpha over the long term—particularly for developed market currency pairs.

Of course, this is not to say that a view on the currency pair isn’t important. Even if relationships are unsteady, there is still some information to be gleaned for FX when oil prices trend a certain way, or if we do see a degree of central bank divergence. Indeed, this will always be an important input for projecting returns for a hedged or unhedged investment.

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Bottom Line: Unpredictable Impact

The bottom line is that while FX fluctuations do impact returns, the direction in the short or long term is not reliably predictable. So, the decision of whether to hedge or not hinges on other considerations.

How to Approach the Hedging Decision

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Hedged vs Unhedged ETFs

For Canadian investors, there are a lot of domestic ETFs that allow for participation in the U.S. markets. For those that are denominated in CAD, issuers offer both hedged and unhedged versions depending upon the investor’s preference. Also, there are options for those investors to instead buy USD-denominated ETFs that track U.S. markets, but trade on Canadian exchanges.

Since mid-2021, Canadian investors who wanted access to the S&P 500 would have been better off using an unhedged ETF (such as ZSP, which is the BMO S&P 500 Index ETF). That’s primarily because the CAD has weakened relative to the USD over that time frame, which has provided an additional return via the currency on top of the underlying. Even though this ETF is listed on the Canadian exchange, the underlying US stocks benefited from both the stock price change and that they are priced in USD. While that was a good outcome for that time period, it was not predictable in advance.

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Hedging USD to CAD & ETF Volatility

Focusing on overall historical returns masks something else that’s important to consider – the ups and downs along the way. Indeed, the ZSP offers another advantage relative to its cousin ETF which hedges for FX risk (ZUE or BMO S&P 500 Hedged to CAD Index ETF). That advantage being that it’s far less volatile. For instance, the chart below shows a comparison between the 90-day realized volatility for the ZUE and ZSP over the past few years.

Most of the time, it’s the unhedged ETF (ZSP) that has the lower volatility. What this means is that investors who hedged their exposure would not only have had lower returns during this time period, but their volatility profile would have increased as well.

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Volatility & Correlation

Admittedly, that feels counterintuitive. After all, shouldn’t hedging FX risk mitigate volatility given that currency risk is negated?

Unfortunately, it’s not that simple. Recall, that when a Canadian investor buys an unhedged U.S.-tracking ETF, that investor is effectively long the underlying asset and the USD. Over the past several years, the performance of the USD has been (directionally) inversely correlated with the S&P 500. This is due to the USD’s appeal as a liquid safe-haven during periods of risk-off.

That means that by not hedging their USD risk, Canadian investors are adding an uncorrelated or potentially negatively correlated asset. That is similar to the concept behind using a mix of stocks and government bonds. Their price tends to fluctuate slightly in opposite directions which reduces volatility at the margin.

The underlying assets have similar long-term risk and expected return.

This is how diversification works best to reduce risk without reducing long-term return. [LD: Sometimes called “the only free lunch in investing.” I love free lunches.]

To Currency Hedge or Not? A Simple Rule.

As a general rule, for any ETF that tracks a foreign market, if the basket of underlying securities is…

1. Negatively correlated to the foreign currency -> there is a diversification benefit from currency exposure
2. Positively correlated to the foreign currency -> there is less of a diversification benefit from currency exposure

In the case of I), the unhedged version of the ETF would provide less volatility than the hedged version. For II), the reverse is more likely to be true.

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CAD-Hedging & Equity Markets

For a Canadian investor looking to increase allocation to broad risk in the U.S. (say the S&P 500), it makes more sense to stick with an unhedged ETF (ZSP). However, it is important to realize that correlation regimes can change. For example, while government bonds and stocks usually have a negative correlation overall, there are periods when that changes. A recent example was in 2022 when interest rates rose to fight inflation. Both equity and bond prices dropped. This possibility applies to the US stock and currency correlation too.

For instance, let’s say the regime flips, and the USD becomes positively correlated with broad risk. In that scenario, the Canadian investor would likely have to consider a hedged ETF – provided that the CAD isn’t underperforming the USD in that environment. An environment in which this scenario makes sense could be if there is a USD-specific shock that doesn’t impact US equities. One scenario in which this could happen is if the market starts attaching a greater premium in the USD for sustained budget deficits.

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CAD-Hedging & Bond Markets

The risk to the USD’s behavior as a “safe haven” asset due to government deficits raises another important point. While the relationship between US equity and the USD has a low to negative correlation, government bond and a country’s currency have a different relationship. We will have to unpack that further in a follow-up post.

Practical Implementation

All told, the above provides a framework for hedging decisions for our readers when it comes to investing outside of the Canadian equity market. Making a hedging decision based on your view of future currency changes is challenging. However, understanding the correlation between the currency and a foreign equity market is useful. A negative correlation can dampen volatility. Much like our friend Hamlet in his famous speech, having a plan allows investors to “take arms against a sea of troubles—and by opposing (potentially) end them.”

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