Wednesday, August 24, 2011

The Problem with Currency Hedging

Vanguard announced yesterday that they will open 6 Canadian-domiciled ETFs. Two of these ETFs cover indexes of U.S. and international stocks. Unfortunately, they also incorporate currency hedging back to Canadian dollars. This takes away the risk protection that I’m looking for, as I’ll explain.

Here are the 6 ETFs Vanguard announced:

– Vanguard MSCI Canada Index ETF
– Vanguard Canadian Aggregate Bond Index ETF
– Vanguard Canadian Short-Term Bond Index ETF
– Vanguard MSCI U.S. Broad Market Index ETF (CAD-hedged)
– Vanguard MSCI EAFE Index ETF (CAD-hedged)
– Vanguard MSCI Emerging Markets Index ETF

One of the risks we face as Canadians is that the Canadian economy will falter and fall behind the rest of the world. As a proud and confident Canadian, I don’t think this will happen. But when I think through the many possibilities, a faltering Canadian economy would cause us big financial trouble.

Imagine that at some point in the near future the world stops buying our oil and our economy takes a big hit. Government debt grows and we face 30% inflation for a decade. The Canadian dollar drops to 10 U.S. cents. All our imports cost 10 times what they used to cost when measured in Canadian dollars.

If I hold international stocks without currency hedging over this tough period, I get a 900% boost in returns (measured in Canadian dollars) to help me deal with expensive imports. If I use currency hedging, I get only a modest return on my international investments and can’t afford to buy imports.

The argument in favour of currency hedging is that Canada may do fine and some other countries may falter. However, this is what diversification is for. I can handle it if 5% of my holdings take a beating. What I can’t handle is having everything I own take a beating if Canada falters. I’m a proud Canadian, but I’d rather have my future depend on the world’s economy as a whole rather than just Canada’s.

5 comments:

  1. It is a hard sell to argue for risk management when recent returns have been poor. It is telling that we had zero currency-hedged funds when our dollar was low and it is hard to find a fund without hedging when our dollar is high. Hopefully Vanguard will also have unhedged ETFs in its lineup eventually for those of us who are interested in it.

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  2. @CC: You're probably right that the popularity of hedged funds now is because hedging has worked out well over the last few years. I hope you're right that Vanguard will eventually offer unhedged ETFs as well.

    I'm happy to try explaining ideas that are tough to sell :-)

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  3. I agree. Much has been made of Canadians needing to diversify their equities outside Canada, but it's also true for currencies.

    I tend to have my bond allocation all in Canadian dollars. I'm pondering the merits of an international short term bond ETF in addition to or even in place of the XSB (Canadian short term bond ETF).

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  4. @Mike: If you bond allocation is high enough it might make sense to go international, but if your stocks dominate, you may get enough exposure to foreign economies with international stocks.

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  5. Very well-explained post for a subject I think is generally misunderstood.

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