Should You Currency Hedge Your Portfolio? | Common Sense Investment with Ben Felix

February 25, 2020

This video is in response to a question from
abe on LinkedIN. Abe wanted to know if he should hedge the
foreign currency exposure of his equities when the Canadian dollar is weak. There is no question that investing globally
is beneficial. Diversification is the best way to increase
your expected returns while decreasing your expected volatility. Diversification is, after all, known as the
only free lunch in investing. When you decide to own assets all over the
world, you are not just getting exposure to foreign companies, but also to foreign currencies. I’m Ben Felix, Associate Portfolio Manager
at PWL Capital. In this episode of Common Sense Investing,
I’m going to help you decide if you should currency hedge your portfolio. If you own an investment in a country other
than Canada you are exposed to both the fluctuations of the price of the asset in its home currency,
and the fluctuations in the currency that the asset is priced in. For example, if a Canadian investor owns an
S&P 500 index fund giving them exposure to 500 US stocks, and the S&P 500 is up 10%,
but the US dollar is down 10% relative to the Canadian dollar, then the Canadian investor
will have a return of 0%. To avoid the impact of currency fluctuations,
some investors choose to hedge their currency exposure. If our Canadian investor had purchased a hedged
index fund, eliminating their currency exposure, they would have captured the full 10% return
of the S&P 500 index without being dragged down by the falling US dollar. Before I continue, I want to be clear that
I am talking about adding a long-term hedge to your portfolio. Trying to hedge tactically, by predicting
currency movements, is a form of active management which you would expect to increase your risks,
costs, and taxes. Now, on with the discussion. Multiple research papers have concluded that
the effects of currency hedging on portfolio returns are ambiguous. In other words, with hedging sometimes you
will win, sometimes you will lose, but there is no evidence of a universal right answer, unless you
can predict future currency fluctuations. With no clear evidence, and an inability to
predict the future, the currency hedging decision stumps many investors. The demand for hedging tends to rise and fall
with the volatility of the investor’s home currency. If the Canadian dollar strengthens, investment
returns for Canadian investors who own foreign equities will fall, which might make the investors
wish they had hedged their currency exposure. While it may seem obvious that a hedge would
have made sense after the fact, hedging at the right time is impossible to do consistently. In a 2016 essay titled Long-Term Asset Returns,
Dimson, Marsh, and Staunton showed that between 1900 and 2015 real exchange rates globally
were quite volatile, but did not appear to exhibit a long-term upward or downward trend. In other words, over the last 115 years currencies
have jumped around a lot in relative value, but you would not have been any better off
with exposure to one currency over another. This was similarly demonstrated in Meir Statman’s
2004 study of US hedged and unhedged portfolios over the 16 year period from 1988 to 2003. The study concluded that the realized risk
and return of the hedged and unhedged portfolios were nearly identical. If there is no expected benefit to hedging
your foreign equities in terms of higher returns or lower risk, why would you hedge at all? It is always important to remember why we
are investing. Most people are investing to fund future consumption,
and most Canadians will consume in mostly Canadian dollars. Hedging against a portion of currency fluctuations
might help investors capture the equity premium globally while limiting the risks to consumption
in their home currency. With that being said.. It is typically not a good idea to hedge all
of your currency exposure because because currency does offer a diversification benefit. Well, it seems like we’re back to square
one, trying to decide whether we should hedge or not. There is no evidence either way. You would not expect a difference in long-term
risk or return from hedging. Currency hedging at least a portion of your
equity exposure has the benefit of keeping some of your returns in the same currency
as your consumption, but too much hedging removes the diversification benefit that currency
has to offer. In the absence of an obvious answer, I think
it makes sense to take a common sense approach. If you’re going to hedge, don’t hedge
all of your currency exposure – I wouldn’t hedge more than half of the equity portion
of your portfolio. If you don’t want to hedge, that is ok too. Remember that there is no evidence in either
direction. Whatever you choose to do, understand that
there will be times when you wish that you had done something different. If the Canadian dollar rises, you might wish
that you had hedged. If it falls, you might wish you were not hedged. At those times, the worst thing that you can
do is change what you are doing. The best thing that you can do is pick a hedging
strategy and stick with it through good times and bad. Join me in my next video where I will tell
you if you should invest in high yield bonds. My name is Ben Felix of PWL Capital and this
is Common Sense Investing. I’ll be talking about a lot more common
sense investing topics in this series, so subscribe and click the bell for updates. I want these videos to help you to make smarter
investment decisions, so feel free to send me any topics that you would like me to cover.

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  • Reply Mathew Greyell November 25, 2017 at 11:21 am

    You should have more views and subs, really educational. I really like your visuals. Good job man. With what you were saying about the fluctuations of all currencies since 1900, how do you think crypto currencies will fit into that trend?

  • Reply Commando303X April 18, 2018 at 1:16 am

    Thank you very much for sharing these videos — I appreciate their sincerity, pragmatism, and accessibility.

  • Reply John Paul June 19, 2018 at 7:59 pm

    Awesome video.

  • Reply J B July 8, 2018 at 9:02 am

    You forgot to mention performance drag due to hedging. Mutual funds and ETFs hedge currency by using derivative contracts, and these derivatives incur trading costs and are not perfectly efficient hedging vehicles. As a result, ETFs that use currency hedging suffer a massive performance drag. For XSP the drag has been 1% – 2% per year (compare IVV performance to XSP). This is such a big performance loss that it wipes out any possible benefit of hedging, which as you point out, is not even believed to be beneficial. I don't see any reason to hedge when there is such a bad performance cost.

  • Reply Mighty221187 August 18, 2018 at 2:06 pm

    What about when you factor in currency conversion fees with the non-hedged equity?

  • Reply Modality August 28, 2018 at 6:31 am

    I’m Ben Felix, Associate Portfolio Manager at PWL Capital.

  • Reply Shawn Penrod September 19, 2018 at 11:22 pm

    ben felix do you think investing in old curreny is a good idea and is it a interest bearing income?

  • Reply Shawn Penrod September 20, 2018 at 5:06 pm

    ben felix so its a non bearing interst and is it a good idea to invest in?

  • Reply Eric Ness January 1, 2019 at 5:10 pm

    That really clears up hedging for me, thank you for making this video!

  • Reply gingerjames February 9, 2019 at 9:13 pm

    Since long term currency prices are neither long or short, then wouldn't a return to mean strategy work well?

  • Reply Harold Govender May 18, 2019 at 11:57 am

    If one analyses the behaviour of various currencies against each other a definite pattern seems to emerge especially with certain geographic areas. Depending on where one resides would a hedging strategy not lead to better outcomes? I wholeheartedly agree that some foreign currency exposure is needed for diversification purposes. The question is how much? I've read that one should have the bulk of investments in the home currency as the future liabilities need to be funded in this currency.

  • Reply Sandermatt87 May 30, 2019 at 8:28 pm

    If you invest in an index that goes up by 10%, but the currency goes down by 10%, you are down by 1% (0.9*1.1=0.99). And if the currency goes up by 100% but the stock down by 100%, well, its gone.

  • Reply Jonathan Ball June 27, 2019 at 6:40 pm

    My currency (GBP) is at a 45year low relative to the USD and I’m a long term investor, so the way I look at at it, there is much more negative risk than positive risk from investing in US stocks. At the moment I’m just trying to focus mainly on uk stocks to avoid the currency risk. 10 years ago it was 2 $/£ now 1.27 $/£… I don’t want to waste money paying for hedging the currency but if it were back to 2$/£ I would certainly have all my stocks over the other side of the pond!

  • Reply Winona Daphne July 6, 2019 at 3:26 am

    "Whatever you choose to do, understand that there will be times where you wish you had done something different." — wise words to live by

  • Reply Jae Oppa July 30, 2019 at 10:45 pm

    thank you for this video!

  • Reply Jae Oppa July 30, 2019 at 10:45 pm

    Would love it if options trading were covered

  • Reply Alexander Farid August 12, 2019 at 3:24 pm

    Thanks for the insight. In Germany, most robo-advisors offer partially hedged portfolios. I would like to know your take on popular portfolios that are recommended for beginners like the Ray Dalio's All Weather Portfolio or Gerd Kommer's World-portfolio. Adding that Dalio's portfolio could be adjusted to be more internationally diversified since it is focused on the US. Which one would you recommend?

  • Reply Chathura Ekanayake September 11, 2019 at 7:29 am

    What about emerging market etfs. Isn't that best to hedge those equities?

  • Reply galaxyS3 mini November 4, 2019 at 4:41 pm

    Thanks ! I really enjoy your videos. Very informative. Facts only, no bullshit. Greetings from germany

  • Reply mrk hrk November 9, 2019 at 6:55 pm

    Hi, can anyone(preferably Ben) riddle me this HYPOTHETHICAL dilemma please: Lets say I invest 100CAD into an S&P500 index ETF, that has a physical structure(it buys the underlying stocks) and is currency unhedged in CAD(meaning CAD are exchanged for USD and USD are used to buy the underlying assets and therefore the fx rate should be reflected in the final value of the fund). Now lets say the CAD/USD fx rate at the time of purchase is 1:1. After a year, the S&P500 index grows by 100%, meaning the value of the assets in USD becomes 200 USD. Now lets say that the CAD/USD fx rate becomes 2:1. Therefore, my initial investment of 100CAD should now be worth 400CAD. Thats a 300% performance, instead of 100%. So, would that be truly what happens? Beacuse if it was hedged, my investment would clearly now be worth 200CAD. But in the unhedged case, the index ETF would report 300% total performance, instead of 100%, therefore it could be said it no longer tracks the index. Or is it the case that I am right, but when you look on published index ETF info(in its KID/website etc.), it always lists the performance of the ETF in the original currency of its underlying assets, while its actual NAV performs differently due to currency exchange rates? Thanks!

  • Reply Ronen Margulis November 15, 2019 at 5:22 pm

    Thanks Ben! What about the hedging costs? Were they taken into consideration?

  • Reply Patrick Law November 19, 2019 at 6:09 pm

    "at some times you wish that you had hedged…at some times you may wish that you had not hedged…the worst thing that you could do is to change what you are doing…"
    I don't understand this statement. Why is it the worst thing that I could do is to change what I am doing if it doesn't matter one way or another what I do? In other words, for it to be the "worst thing" to do, then it would have to matter whether I hedge or don't hedge. Please explain what you mean by this statement.
    Perhaps what you mean is one of the following?
    1. if you look at the market and wish you had hedged last year and then change to hedging this year, it is more likely that the 'right' answer will be to not hedge. If this is the case, then I can simply do the reverse of whatever happened last year and beat the odds of a consistent approach.
    2. Changing currency hedging is likely to add friction (fees, spreads, etc.) to the portfolio while a consistent hedge or not hedge decision will avoid this.
    3. It is a slippery slope from continually changing my currency hedge to active investing.

  • Reply Jonathan K December 12, 2019 at 4:38 am

    What exactly are you staring at in this thumbnail? Haha.

    Ok, so if the u.s. dollar is strong and they have a (alleged) coming recession and crazy debt to gdp ratio, would it be better to hedge?

  • Reply jacquelineazure December 28, 2019 at 5:30 pm

    It's Sad that Ben Felix has 72k subscribers, while "how to bag a millionaire" channel has 500k.

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