Currency hedge has a known cost with an unknown payoff

Morningstar’s director of investment management says the volatility of a currency exposure evens out over time.

Ashley Redmond 10 June, 2014 | 5:00PM

 

 

Ashley Redmond: I'm Ashley Redmond for Morningstar.ca and it is Global Diversification Week here at Morningstar Canada. I'm here with Michael Keaveney to discuss currency.

Michael, thanks so much for joining me.

Michael Keaveney: It's great to be here Ashley.

Redmond: So Michael, today we're going to be talking about currency hedging. It's a popular strategy here in Canada. For example ticker, XSP, that's the iShares S&P 500 Hedged to the Canadian Dollar.

Canadians have over $2 billion invested in XSP and it's one of the largest ETFs in Canada, and it's cheap. So, Michael are you in favour of currency hedged funds?

Keaveney: Well, Ashley, I'm in favour of investors having the tools that they need to take on the investment risks and opportunities that they want, and to be able to sidestep those that they want to avoid. In that sense the availability of a currency hedge is a good thing because it gives investors a tool to make two separate decisions: Do I want exposure to a market? And do I want exposure to the currency? Like any other tool currency hedging comes with limitations and costs.

Redmond: So does the value of currency hedging change from country to country? Does it make more sense to hedge in the U.S., but not in Canada due to the market or other factors?

Keaveney: Well country does matter for the value of a currency hedge, especially as it applies to minimizing overall portfolio volatility. So for example, research has been done on the movement of the Canadian dollar versus the U.S. dollar, and it makes a reasonably strong case against Canadian equity investors hedging the U.S. dollar exposure of the stocks that they hold south of the border. Now, that's because there's a negative correlation between the direction of U.S. equity stock prices and the value of the U.S. dollar versus the Canadian dollar.

The U.S. dollar is generally viewed around the world as a safe haven during tough times and a good example of that was during the financial crisis. The S&P 500 Index was down about 37% in 2008, yet Canadian investors who held the same basket of U.S. stocks without a currency hedge were down a more modest 23% over the same period.

Redmond: Does a currency hedge add volatility to your portfolio?

Keaveney: Well, it did in that particular instance, but for other examples they run counter. So for example, Canadian investors with global fixed income, they can actually benefit with a currency hedge as they apply it to their international fixed income investments. And since non-U.S. markets don't have the same safe haven currency status there is evidence that currency hedging for Canadians in those markets also reduces portfolio volatility.

Now, what we're talking about here—these reduced volatility benefits—they generally are experienced in the short-term. We believe that over the longer term these ups and downs in currency market movements generally even out over time.

Redmond: What are some of the other factors that investors need to consider with currency hedged funds?

Keaveney: Well, we haven't yet discussed costs and there is an old adage in the investment world that currency hedging is a known cost with an unknown payoff. And what we mean by that is that you pay for the service, but you don't necessarily receive a positive payback in the form of better upside.

It's also fair to note that currency hedging is never exact. There is some tracking error as we call it between the actual hedge that's put in place in practice and the theoretical perfect hedge, and that sometimes takes investors by a surprise.

Now finally, it's also important to note that not every global investment fund out there actively advertises the currency hedge that it is doing or isn't doing. So any time you see a fund that does have global investment exposure, it's very important for you to check below the surface and see what the hedging policy is.

In instances where judgment is involved, you want to gain comfort in the process that is used— the expertise of the people involved in making what's an inherently difficult short-term investment decision to get correct.

Redmond: Some great advice. Thanks so much, Michael.

Keaveney: Thank you.

Redmond: Keep checking back for more on Global Diversification Week.

            

About Author

Ashley Redmond

Ashley Redmond  Ashley Redmond is a Vancouver-based freelance writer.