Many U.S. stock mutual funds and ETFs available to Canadians come with currency hedging to eliminate changes in the relative value of the U.S. and Canadian dollars from the fund returns investors get. This may seem natural to many, but it seems very strange to me. This comes from my view of different world currencies as a kind of asset class rather than absolute measures of value.
The basic idea of currency hedging is that if a U.S. fund goes up 10% as measured in U.S. dollars, a Canadian investor will see his investment rise 10% as measured in Canadian dollars, even if the Canadian and U.S. dollars move relative to each other. In reality, Canadian investors would usually get a little less than 10% due to tracking errors caused by currency hedging.
Just because the U.S. dollar goes up or down doesn’t mean that the value of U.S. stocks follows. Suppose that inflation rises in the U.S. and drops the value of the U.S. dollar over the course of the next decade. It doesn’t follow that U.S. stocks will drop in value too. U.S. stocks might actually be a hedge against inflation. My intention isn’t to speculate about inflation and the direction of stock prices but to point out that U.S. stock and the U.S. dollar are separate asset classes. They affect each other, but don’t move in lock-step.
What if the value of a U.S. stock fund were reported in ounces of gold rather than U.S. dollars? We might hear that one year the fund units rose from 5% of an ounce of gold to 5.5% of an ounce of gold. In this case, Canadian investors might want to hedge the value of gold instead of hedging the U.S. dollar.
We can make this even sillier. What if the value of a U.S. stock fund were reported in units of shares of Coke? Would it then make sense for Canadian investors to hedge the value of Coke shares against the Canadian dollar? This would create a Franken-fund whose value tracked U.S. stocks times the Canadian dollar divided by the value of Coke shares.
When I think of the value of a collection of businesses such as U.S. stocks, this value is independent of any particular currency. What happens to the U.S. dollar will certainly affect these businesses, but if the U.S. suddenly adopted some other currency such as the Euro, these businesses would still have their value which is driven by demand from their customers. I’m content to own U.S. stocks for the inherent value of their businesses rather than the measure of this value in a particular currency.
Note that currency hedging is different from whether a fund is purchased with Canadian or U.S. dollars. It would be possible to create a fund that trades in Canadian dollars, but invests in U.S. stocks. This saves investors from having to do currency conversions themselves. I wish there were low-cost index funds of this type in Canada that didn’t have currency hedging bolted on.