In today’s global economy, we have witnessed a steady increase in the number of highly diversified portfolios of international assets. With this comes the challenge of managing currency volatility in an uncertain environment of global macro risks. So what is the best approach to managing currency risk?

It is a commonly held notion that currency hedging of foreign equities reduces overall portfolio risk. However, there are many market participants who also believe that, over the long-run, currency exposure does not create or detract value. In other words, there is no expected return from currency exposures.

Within Canada, hedging beliefs tend to follow the path set by the rest of the world, which is to say, there is no clear direction on how to hedge the currency exposure of foreign equity portfolios. Some participants fully hedge, others hedge half their exposure and still others hedge none of the foreign currency exposure in equity portfolios. All of these approaches have the potential for investors to miss some unique opportunities for Canadian investors, particularly given that we have the world’s largest equity market as our main trading partner.

Examining the standard deviation of U.S. equity returns reveals that Canadian investors would materially reduce risk by remaining unhedged on the currency component of the portfolio. This stands in stark contrast to investors in most other countries, who are generally indifferent from a risk perspective, to hedging their U.S. equity currency exposure. In Greystone’s analysis, the only other country to benefit from reduced risk similar to Canada is Australia.

To ensure this was not an anomaly, we examined the data as rolling four-year periods. This confirms the consistency of lower risk for unhedged versus hedged U.S. equity investors in Canada.

With the exception of the appreciating markets prior to the 2008 financial crisis, unhedged U.S. equity investing appears to be less risky for Canadian investors. We can also see that retaining U.S. currency exposure during stressed markets provides increased benefits. A hedged investor’s volatility significantly increased post the tech wreck in 2000 and financial crisis in 2008. Overall, a long-term analysis of currency volatility reveals a fairly consistent risk reduction for Canadian investors in unhedged U.S. equities.

Why is this interesting? Both Canada and Australia are exporters, largely of commodities. Understanding why Canadians benefit from unhedged U.S. equity exposures can be tied back to this economic reality. Strong U.S. equity returns are often complemented with:

  1. a rally in commodities to fuel economic growth; and
  2. higher exports to the U.S. from Canada.

The appreciation of commodities and increased exports to the U.S. will strengthen the Canadian dollar over the U.S. dollar. This, in turn, will moderate strong U.S. equity returns for an unhedged Canadian investor (remember that a stronger Canadian dollar and weaker U.S. dollar will result in lower unhedged U.S. equity returns).

In a weak market, the opposite holds true. Low economic growth and commodity demand will dampen commodity prices and Canadian exports to the U.S. This will raise the value of the U.S. dollar over the Canadian dollar, thereby providing an offsetting currency appreciation against weak/negative U.S. equity returns.

For an unhedged Canadian investor, this path of weaker returns in strong U.S. equity markets and stronger returns in weak U.S. equity markets serves to reduce overall portfolio risk. Of course, if one has a strong view on currencies, they may wish to hedge. However, if there is no anticipation that the Canadian dollar will appreciate relative to the U.S. dollar, Canadian investors can benefit from a risk reduction by remaining unhedged on the currency exposure of their U.S. equity portfolios.

This article is for informational purposes only and was developed from sources believed to be reliable. No representation or warranty is made as to its accuracy or completeness. This article is not meant as investment advice and should not be considered a recommendation to purchase or sell any particular security or to implement any particular investment strategy. There is no assurance that any predictions or projections will actually occur. Past performance is not necessarily indicative of future results.

Copyright © 2020 Transcontinental Media G.P. Originally published on benefitscanada.com

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