A look at key considerations around hedging foreign investment exposure

The reduction of a home-country bias, especially in equities, and an increase in the percentage of non-market-correlated strategies in investment portfolios are two prominent investment themes that have emerged over the past few years.

Decreasing the allocation to Canadian equity in favour of global equity or alternative investments has been a profitable trade — at least until recently — given the declining price of oil and the resulting depreciation of the Canadian dollar. Reducing equity exposure in favour of alternative investments has also had a positive impact on portfolios given equity market volatility.

Read: Plan sponsors considering options amid market volatility

One of the implications of reducing home-country bias has been an increase in exposure to foreign currencies. Foreign exchange movements can have a positive or negative impact on the value of foreign investments, depending on the markets’ view of the relative strength or weakness of the home currency. When investing outside of the home country, the investor has to decide whether to hedge a portion or all of that exposure and whether to do so across all currencies.

Hedging involves purchasing currency derivatives (futures, forwards and options) in order to protect the portfolio against the adverse impact of currency movements. The goal of a currency hedging program can also be to mute the impact of currency volatility in order to create a smoother return pattern. More mature pension plans are often more sensitive to currency movements as their pension payments are greater than their contributions.

Read: Weak loonie triggers jump in pension plans’ risk appetites

For the past few years, it has been advantageous for Canadian-dollar investors to remain unhedged and instead be fully exposed to currency movements as the Canadian dollar has depreciated against the world’s major currencies, notably the U.S. dollar. In fact, hedging a portion or all of the foreign exposure has increased portfolio volatility as the Canadian dollar has tended to depreciate when the equity markets have also experienced negative returns. There has been a large correlation between the level of the Canadian dollar and the price of oil, and energy tends to have a material position in most equity markets.

Since December 2015, however, the Canadian dollar has appreciated against foreign currencies, especially the U.S. dollar, rising from below 70 cents (U.S.) in January 2016 to its present level of approximately 77 cents. This begs the question: What should investors do with respect to their foreign exposures? Is it too late to hedge?

Investors can ask a number of strategists for their view and each will provide a different viewpoint as to what constitutes fair value for the Canadian dollar versus the U.S. currency. Consensus would be in the range of 75 to 80 cents (U.S.) over the long term. However, those last few words are key. Currencies trade on non-financial factors and often are above or below their fair value.

Read: Pension plans and the Canadian dollar dilemma

Should investors hedge their foreign exposures? There are a number of factors investors should consider in making such a decision, including the absolute dollar value of the foreign exposure, the governance requirements and the cost of doing so.

Starting with the latter, there is a cost to implementing a currency hedging program. Hard costs relate to the purchase of the derivate contracts, usually through a manager, and the potential to have to settle them when the currency moves the wrong way. While the investor will be better overall when settling a contract as the asset will have appreciated more than the cost of settling the currency, it still has to source the funds. The contracts require time and effort to oversee and administer and, even if executed through a manager, the work would add an extra manager or product to oversee.

Read: Top 40 Money Managers: Why pension funds are turning to non-core infrastructure

In general, investors have tended to hedge income-producing assets such as foreign bonds, real estate and infrastructure but have varied their hedge exposure to equity assets depending on the level of the Canadian dollar and their risk appetite for variable returns. While such an approach makes sense in theory, if the total foreign assets are less than $100 million, many investors won’t pursue it since the administrative burden and costs associated with a hedge don’t make sense. There are some passive hedged equity products available that might ease the governance requirements, but they require investors to invest passively, something that may or may not gel with their investment beliefs.

It’s also important to address the question of hedging level. As noted, not hedging over the past few years versus the U.S. dollar has been beneficial for Canadian-dollar investors. More recently, partial or complete hedging would have been more profitable for a Canadian-dollar investor. Many investors have set trigger points at which they increase or decrease the percentage hedge in order to take the sentiment out of the decision. For example, one investor I know initiated a partial hedge of 25 per cent when the Canadian dollar fell below 70 cents and increased it to 50 per cent when it reached 75 cents.

There’s no simple answer. But understanding the potential impact on the investments, having a clear sense of the risk appetite, and developing a road map for action where appropriate assists investors in knowing if and when to act.

Read: More Canadians turning to global equities for retirement savings