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Discussion Starter #1
The S&P 500 is up 35% from its low but the loonie has also risen in value up from 77 cents to 85 cents or 10% over the same time frame. Therefore, a Canadian investors who have not hedged their currency exposure did not enjoy the same upside as an US investor (and to be fair, did not experience the same downside when the markets tanked).

My rather strong opinion has been that the costs of hedging are certain (many estimates run at 1% per year) and the benefits are debatable. Unhedged investors take currency risk in the hope that it will provide diversification benefits. It seems to be working but it isn't as much fun when it is working against you :)


The Costs of Currency Hedging

The Costs of Currency Hedging: Taxes
Revisiting the Tracking Error For Currency-Hedged Funds

Let's open up this topic for discussion. Many are of the opinion that the strength of the US dollar over the past year was a temporary phenomenon within a secular bear market in the dollar. What if anything are you doing to hedge against a falling dollar (or rising loonie)?
 

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Very good question.

For my own portfolio, I've got a very good allocation directly in US dollars - I've always considered earning $CAD to be the best hedge against the falling greenback. To hedge against a weak $CAD, I'll be buying more US equities directly when/if the USD drops.

For my wifes' ETF portfolio, never gave it enough thought so I'm happy you raised the topic. I'm eager to hear what others are doing.
 

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Discussion Starter #4
The extra MER is not the only cost of hedging. It comes in the shape of tracking error and it can be quite horrendous.

Currency Neutral Funds Performed Poorly (Again) in 2008

For instance, XSP underperformance of IVV returns is:

2006 - 1.72%
2007 - 2.29%
2008 - 3.4%

Similarly, TDB904 underperformed TDB952 by:

2006 - 1.1%
2007 - 1.8%
2008 - 1.63%

As you can see, the tracking error is huge as it includes the costs of hedging. Hedging is not free and investors pay for it through tracking errors.
 

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CC - my impression is that you don't believe there is any value in getting the currency hedged options ;) - but do you do any sort on your own?

Aside from trying to time currency exchanges - is there anything else one could do to hedge against a falling loonie?
 

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Discussion Starter #6
CC - my impression is that you don't believe there is any value in getting the currency hedged options ;) - but do you do any sort on your own?

Aside from trying to time currency exchanges - is there anything else one could do to hedge against a falling loonie?
No. I don't do any currency hedging. I expect hedging costs for individual investors to be similar or more than that for currency-neutral funds though I personally don't have any experience in this area.

In any case, I can see the merits of hedging (ignoring the costs for a moment) only for US dollar holdings. Broad international indexes exposed to many currencies probably don't need any hedging at all.
 

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For my own portfolio, I've got a very good allocation directly in US dollars - I've always considered earning $CAD to be the best hedge against the falling greenback. To hedge against a weak $CAD, I'll be buying more US equities directly when/if the USD drops.

Thats the approach I took. I bought a bunch of American currency when it was at par with the Canadian dollar.
 

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We do not hedge our stock portfolios. Our belief is stolen from other investors who have stated that currency fluctuations tend to iron themselves out over decades.

We don't buy U.S. securities based on the relationship between the USD and CND; we buy U.S. securities when we deem them to be cheap.

Approximately 50% of our net worth is in stock.
 

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Interesting info, CC. I was not aware of the tracking error.

If tracking error is what it sounds like (imperfect tracking of the index), can the error occur *in favor* of the investor given the right market environment?

Also does anyone know if it is possible to own IVV in TFSA? If so, how do they calculate the contribution limit in USD?
 

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Discussion Starter #10
Interesting info, CC. I was not aware of the tracking error.

If tracking error is what it sounds like (imperfect tracking of the index), can the error occur *in favor* of the investor given the right market environment?

Also does anyone know if it is possible to own IVV in TFSA? If so, how do they calculate the contribution limit in USD?
Tracking error is usually positive because of the MER of the ETF, withholding taxes etc. I doubt if tracking error can ever be favourable to investors for currency-neutral funds because the cost of hedging is said to be around 1%. So, you can expect a tracking error of at least 1%.

You can own IVV in a TFSA. The contribution limit of $5,000 is in CAD. The CAD equivalent of any USD contributions (I don't know if you can contribute USD in cash but either way it doesn't matter) would be considered as your contribution. Your brokerage should be able to provide this value for you. That's how it works for in-kind RRSP contributions.
 

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Discussion Starter #12
Jon's column in the post today:

Loonie hedge may be wise

I'm biased but I thought this was the best quote:

However, Bob Cable of the Mississauga-based Cable Group, does not believe long-term investors need to worry about currency effects.

"It is just a guess at any time and the cost of doing so adds up."

He says the one, three and five-year returns of mutual funds available in US$ and C$ versions can show significant differences in returns but this "almost evaporates" when you run the 10-, 15-and 20-year numbers.

In the long run, it's a wash so "hedging is unimportant" for a true investor with a 10-year time horizon, Cable concludes.
 

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However, Bob Cable of the Mississauga-based Cable Group, does not believe long-term investors need to worry about currency effects.

"It is just a guess at any time and the cost of doing so adds up."

He says the one, three and five-year returns of mutual funds available in US$ and C$ versions can show significant differences in returns but this "almost evaporates" when you run the 10-, 15-and 20-year numbers.

In the long run, it's a wash so "hedging is unimportant" for a true investor with a 10-year time horizon, Cable concludes.
Agree.

We don't think about it because over decades it is a non-event.
 

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I've been thinking about this issue for a while, and wanted to reply to this thread, but my thoughts turned out to be so long that I posted it on my blog instead:
When to Buy a Currency Hedged Fund

In short, I agree that for the long term buy-and-hold investor, currency fluctuations probably will even out. However, not everyone has a long time-frame left, so it can be an important issue to think about.

In the case of a US index fund, there might be a CAD fund, a USD fund, and a currency-hedged version of the fund. If we say that we don't want to buy the currency-hedged fund because of additional MER and tracking error, then for someone without the luxury of a lot of time, there is still the question of whether to buy the CAD fund or the USD fund.
 

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Discussion Starter #15 (Edited)
In short, I agree that for the long term buy-and-hold investor, currency fluctuations probably will even out. However, not everyone has a long time-frame left, so it can be an important issue to think about.
Only long-term investors should be in stocks. If an investor has the time frame to be in equities, they have the time frame to be unhedged.
 

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Discussion Starter #18
Do you recommend that people in the withdrawal stage should not be in equities at all then?
That's not what I said. I can't see an investor having a long enough horizon for equities but not long enough for being unhedged. If they are willing to accept the risk of being in stocks, they should be able to accept the risk of currency fluctuations. Why would you want one but not the other?
 

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One piece of feedback I got was that I didn't address more sophisticated currency hedging techniques, like use of futures, which institutions and higher-net-worth individuals might try. I'll take a crack at that one next week in a followup piece. Suggestions as always welcome.

www.wealthyboomer.ca
 

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If they are willing to accept the risk of being in stocks, they should be able to accept the risk of currency fluctuations. Why would you want one but not the other?
I'm not arguing that in the long run, hedging probably costs more than it's worth and that if you are in long enough that currency fluctuations seem to amount to nil. However, I don't think that accepting the risk of equities means that you should accept the risk of currency fluctuations. With equities, I would accept the risk because I hope that I'm holding a productive asset. The risk of currency fluctuations doesn't really come with the promise of anything productive.

So does the risk come with any reward? If not, why would I accept the risk? If it didn't cost me anything to remove that risk, I wouldn't want to assume the risk. However, I agree that in the real world, it certainly does cost something to hedge, and that on top of that, the hedging error has in practice been pretty horrible.

If I am going to accept that risk, then how can I get some reward for it? Say you believe that in the long run, currency fluctuations amount to zero then maybe it's possible to take advantage of that reversion to the mean by selectively buying the hedged or non-hedged versions of funds based on current exchange rates?
 
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