When to hedge the loonie, when not to

It makes sense for Canadians to invest some money in foreign stocks. If you’re a short-term investor, there are cases where hedging against currency risk is appropriate. But don’t hedge against currencies you will need to use abroad.

hedge_the_loonieThe Canadian stock market faces several strikes against it.

First, Canada accounts for a small percentage of the world’s stocks—two per cent or so. This is too narrowly-based for proper diversification.

Second, Canada has many stocks in the volatile resources sector. A well-diversified portfolio, however, also requires high-quality consumer and manufacturing stocks. These are in short supply in our market.

Four strikes against Canada’s market

Third, Canada’s population is aging. Older people usually consume less than the young. This could slow the country’s economic growth. Some developing countries have young populations.

Fourth, many Canadian companies are sitting on piles of what Mark Carney once called “dead money”. (Mark Carney was the former governor of Canada’s central bank.) Also, many Canadian companies rely on selling to the US instead of seeking a larger share of other foreign markets.

As a result, it makes sense for most Canadians to diversify and invest some money abroad. If you lack expertise in foreign markets, you could buy an index fund that would give you positions in a number of a country’s major companies.

You might wonder if you should hedge against the foreign exchange risk. Here’s the advice of Jeremy Siegel, a professor of finance at the Wharton School of the University of Pennsylvania. “Since foreign exchange risk generally adds to the local risk, it may be desirable for investors in foreign markets to hedge against currency movements.

“But hedging foreign exchange risk is not always the right strategy. The cost of hedging depends on the difference between the interest rate in the foreign country and the dollar interest rate; and if a country’s currency is expected to depreciate (typically because of high inflation), the cost of hedging could be quite high.

“For example, even though the British pound depreciated from $4.80 [US dollars] to about $1.60 over the past century, the cost of hedging this decline exceeded the depreciation of the pound. Thus the dollar returns to British stocks were higher if investors did not hedge the decline in the pound than if they did.

“For investors with long-term horizons, hedging currency risk in foreign stock markets may not be important. In the long run, exchange rate movements are determined primarily by differences in inflation between countries, a phenomenon called purchasing power parity. Since equities are claims on real assets, their long-term returns have compensated investors for changes in inflation and thus protected investors from exchange rate depreciation caused by higher inflation in foreign countries.

“Over shorter periods of time, investors may reduce their dollar risk by hedging exchange risk.”

Some countries, including Canada, try to lower their currencies to stimulate exports and the economy. In such cases, hedged investors could protect themselves against foreign exchange losses. At the same time, they could profit from an upswing in the foreign country’s economy.

Don’t hedge currencies you need

Professor Siegel writes, “investors who took hedged positions in Japanese stocks late in 2012, when Prime Minister Shinzo Abe advocated yen depreciation to stimulate the economy, far outpaced the gains made by those who did not hedge the depreciating yen.”

If you spend a considerable amount of time in the US, Europe or elsewhere, then there’s even less need to hedge. That’s because you’ll need the American dollars, euros, British pounds and other currencies when you travel or live abroad. This is especially true if your house and cottage are valued in loonies and you earn a salary or receive a pension in loonies. In such cases, hedging would compound your personal currency risk.

This is an edited version of an article that was originally published for subscribers in the December 7, 2018, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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