Aug, 09, 2013

Foreign Exchange (FX) Hedging

Foreign Exchange (FX) Hedging

We have discussed the rationale for our unhedged strategy previously, but given the significant move in the Canadian dollar and the fact that we have new clients to the firm, it is worth commenting on in greater detail.

Currency hedging imposes costs and acts as a drag on long‐term performance. We will consider hedging our currency exposures only when we believe that a currency is dramatically mispriced. The rest of the time – when a currency is within a range of “fair value” – we are prepared to accept greater short‐term volatility in exchange for longer‐term outperformance.  Smoothing out the short-term moves may make you feel better, but several studies have shown that it is the wrong financial decision over the long-term given the costs involved in doing so.

Don’t just take our word for it.  A client sent us a recent Globe & Mail  article discussing this exact point:

“The Canadian dollar’s recent surge has been a painful one for investors who hold U.S. stocks and funds that do not use hedging.  You did not make a mistake by holding unhedged exposure to U.S. markets. The underperformance of non-hedged stocks and funds stings, but it’s just a passing setback that does not require you to make changes in your portfolio…

Whether you go with hedged or unhedged U.S. holdings, you’ll almost certainly feel like both a genius and a chump in the near term. The reason to stop worrying about hedging is that things even out over the long term. Over the 20 years to June 30, the S&P 500 made 6.8 per cent in Canadian dollars and 7.2 per cent in U.S. dollars. Over the 30 years, the difference between the two approaches amounted to just 0.08 of a percentage point.”

We couldn’t have said it better ourselves and we acknowledge that our strategy has us looking like a chump at the moment.  The costs of hedging change over time, but let’s assume an average annual cost of 1%.  Over a 30-year period, that amounts to net returns that are 34.8% lower.  Compare that cost with the 0.08% difference in 30-year returns cited in the article.  The journey may be smoother with a hedged portfolio, but at a very large cost to your ultimate returns.

Our bet remains that history will repeat we will be further ahead over the long-term by accepting some short-term volatility in exchange for saving the hedging costs.  And the impact on long-term returns are what we will always remain focused on when making portfolio decisions at GreensKeeper.

Michael McCloskey,

Founder & President