When investing outside of Canada, whether it be into Fixed Income or Equities, hedging your foreign investments to the Canadian $ serves two primary purposes:
Fluctuations in exchange rates will affect investment returns depending on whether the Canadian dollar strengthens or weakens against a foreign currency.
For example:
If the Canadian $ strengthens against the US $ from $0.70 to $0.80, then the value of the investment made in the US $ currency securities will be impacted negatively.
If the Canadian $ weakens against the US $ from $0.80 to $0.70, then the value of the investment made in the US $ currency securities will be impacted positively
Short-Term Reduction of Volatility
In the investment industry, volatility represents the size and frequency of price fluctuations in a security or portfolio. Standard deviation is the commonly used measure of volatility and is represented as a percentage that shows how much the return on an investment is deviating from expected normal returns. If a portfolio regularly rises or falls 5% over the course of a week it will have a high volatility. Part of a prudent portfolio design strategy is to try to limit volatility where possible as investors are not keen to see their portfolios having large swings in value.
Since trading occurs daily in both stocks and currencies, an investment outside of Canada into foreign markets can exhibit higher volatility that normal. Not only do you have the ups and downs of an index, but also intraday changes in the Canadian $ vs. Foreign Currency exchange rates. Over a longer period, the effect on volatility is minimized, but over a short-term period, such as several months or a year, it can be significant.
The graph below shows the impact that currency hedging can have on the volatility in an investment over several time periods. The orange bars represent data for the unhedged ETF and blue bars are the currency hedged ETFs.
Graph prepared by LINK Plan Management. Time periods are backward-looking as of December 29th, 2017. CDN $ Hedged data is from the iShares Core S&P 500 Index ETF (CAD- Hedged) ETF and unhedged data is from the iShares Core S&P 500 Index ETF. Graphs use daily closing price adjusted for both dividends and splits provided by Yahoo Finance.
At LINK, we follow a passive, index tracking Asset Allocation driven investment management process. We do not consider ourselves experts in exchange rate forecasting and therefore remove that variable from the equation by hedging foreign investments where we are able. If a foreign stock market index rises 10% we want to make sure our clients are participating, if the Canadian $ were to strengthen against the currency of that index it would erode the investment returns.
Notes on risk: All investing is subject to risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or protect against losses in a declining market. There is no guarantee that any given asset allocation or mix of securities will meet your investment objectives or provide you with a given level of income.
