By: Larry MacDonald

To hedge or not to hedge the currency, that is the question. A reader asks if he should be buying the currency-neutral version of mutual funds/exchange-traded funds when diversifying into foreign markets. This question is often heard from readers — perhaps because many investing books skip over it or leave readers dangling (one example, as I recall, is William Bernstein’s The Four Pillars of Investing).

Serious students of investing, however, know there are a number of empirical studies from academia and elsewhere that conclude there is no need to hedge currencies if the investing horizon is long term. Going by the historical data (for U.S. investors venturing into multiple foreign stock market), returns are nearly the same — as noted in this post last May.

Yet, structural imbalances (e.g. trade and fiscal deficits) in the U.S. continue to accumulate beyond thresholds that typically have triggered sustained currency depreciation in other countries. Perhaps past empirical studies, covering periods when U.S. imbalances were less extreme, need to be taken with a grain of salt.

Even if currency fluctuations do average out over the long run, such an outcome provides little solace to investors who do not have a long time before they need the funds, such as persons who will be retiring in less than 15 years. Unhedged foreign funds are more suitable for younger people — although even here there seems to be a major caveat.

What’s the caveat? While stocks can be expected to return 6% to 10% annually over the long run (going from the past record), there is no expectation of a similar long-run, positive return for currencies. Currencies are only expected to cycle in long swings around the investor’s breakeven point, which means there is a risk the cycle may not be at, or above, breakeven when the time for withdrawal comes.

Perhaps, then, the decision to hedge depends on one’s risk tolerance. Some may see the extra 15 basis points or so in the fund’s annual fees (plus any tracking error) as an acceptable insurance premium to pay for a more certain outcome. Others will see the premium as too expensive, especially when the currency contribution can be positive just as well as negative.

Canadian investors often ask whether or not they should hedge the currency when investing in funds that track U.S. stocks. This is a different situation from what most empirical studies examine (i.e. impact of several fluctuating currencies in terms of the U.S. dollar).

There seems to be, to a greater extent, certain regularities in the Canadian and U.S. dollar exchange rate that open the door to an active approach. Specifically, the loonie has a lengthy history of trading in a range roughly between $0.70 (U.S.) and $1.00 (U.S.), so one may benefit from overweighting currency-neutral funds when the loonie descends toward the lower boundary (as it is now) and shifting to an overweight in unhedged funds when the loonie approaches its upper boundary.

When the loonie is getting close to its lower boundary, history says it is more likely to go up than fall further, so a currency-hedged foreign fund may be the answer for the Canadian investor. Conversely, when the loonie approaches its upper boundary, it is more likely to fall than rise, so an unhedged fund may be more appropriate.