Currency hedging is similar to insurance, which you buy to protect yourself from an unforeseen event. Currency hedging is an attempt to reduce the effects of currency fluctuations on investment performance. To hedge an investment, investment managers will set up a related currency investment designed to offset changes in the value of the Canadian dollar. In general, currency hedging reduces the increase or decrease in the value of an investment due to changes in the exchange rate. In other words, it aims to even out results.
Investors shouldn’t make long-term investment decisions based on expectations of future foreign currency movements. Here are three reasons why:
1. It is extremely challenging to predict the timing of currency movements.
Predicting when a particular currency may rise or fall is a very difficult task, and is therefore best left to investment professionals.
Exchange rate movements tend to vary over time and can be severe over shorter time periods.
Over the short-term currencies can vary significantly
Rolling 1 year returns (calculated monthly). Difference between S&P 500 Index return in C$ and S&P 500 Index return in US$. Source: Morningstar Direct as of February 28, 2022.
2. The impact of currency movements tends to diminish over time.
While exchange rates fluctuate from year to year, the impact of currency on investment returns tends to decline over time.
Impact of currency diminishes over time
As at February 28, 2022. Difference between S&P 500 Index return in C$ and S&P 500 Index return in US$.
Source: Morningstar Direct.
3. In a diversified portfolio, currency movements tend to even out.
A well-diversified portfolio has exposure to many different currencies. The interplay between baskets of currencies is sometimes referred to as a natural hedge.
There are two main ways portfolio managers manage foreign currency risk :
- Forward contracts – The portfolio manager can enter into an agreement to exchange a fixed amount of currency at a future date and specified rate. The value of this contract will fluctuate and essentially offset the currency exposure in the underlying assets. Keep in mind that the investment will not benefit if currency fluctuations work in its favour.
- Options – For a fee, options give the holder the right, but not the obligation, to exchange one currency for another at a set rate for a certain period of time. This reduces the potential that a change in exchange rates will affect the return on the investment.
Hedging removes the impact of currency volatility so that the main factor in the fund’s return is the performance of the underlying securities.
| Effects of changes in currency value: | On an unhedged US$ portfolio | On a fully hedged US$ portfolio | On a 50 % hedged US$ portfolio |
|---|---|---|---|
| C$ ↑ 10 % vs. US$ | -10 % | 0 % | -5 % |
| C$ ↓ 10 % vs. US$ | +10 % | 0 % | +5 % |
It’s important for investors to consider their appetite for currency risk prior to investing in a mutual fund that holds securities with foreign currency exposure. Remaining unhedged may be appropriate for some investors, but not for others.
| Hedged/Currency neutral | Unhedged | |
|---|---|---|
| Time horizon | Short-term | Long-term |
| Diversification | Concentrated portfolio | Portfolio well-diversified by currency |