The Morningstar Dictionary: Currency hedging

Eliminating currency effects from returns exposes you to the pure performance of your fund's holdings.

Christian Charest 14 June, 2017 | 5:00PM

 

 

When a fund invests in stocks or bonds issued outside of Canada, it exposes you not only to the ups and downs in the prices of these securities, but also to the fluctuations of the currencies in which they're issued versus the Canadian dollar.

For example, let's say you buy a U.S. equity fund. In all likelihood you'll buy it using Canadian dollars, but the fund then has to convert these to U.S. dollars in order to buy stocks on the U.S. stock market. Similarly, when you look at how a fund has done, its daily prices have to be converted back into Canadian dollars in order to calculate the returns that you effectively get.

Currency movements can sometimes add to the returns of foreign funds, but they can also hurt them. During the month of May 2017, the S&P 500 Index had a total return of 1.4%, but over the same period the U.S. dollar depreciated by 1.2% against the Canadian dollar, so funds sold in Canada that invest in U.S. stocks had very muted returns.

That is, unless they used what's called currency hedging. Some funds will use derivatives in order to eliminate the effects of currency movements and present you with the pure performance of the underlying securities. It's as though you were investing in the home currency rather than Canadian dollars.

A lot of fund companies offer both a hedged and an unhedged version of the same fund, while some fund managers take a more active approach to currency management, hedging some investments where they think the currency exposure is too risky, and leaving others exposed when they believe it to be beneficial.

So how to decide which is best for you? Currency exposure can add a layer of diversification to a portfolio, which can help in the long run. Also, over long periods currency fluctuations tend to even out. However, hedging does reduce volatility in the short term and takes away an element of uncertainty, allowing you to tailor your portfolio based on the fundamentals of the market.

We've written a lot about currency hedging on Morningstar.ca. Below the video player are links to a few articles we've published recently.

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Christian Charest

Christian Charest