In its Fourth Quarter 2010 outlook (available here), money manager Leith Wheeler weighed in on the contentious topic of whether investors should hedge their foreign currency exposure. Here are some highlights from the report:

– A 2007 survey of pension plans found that almost 80% of small and mid-sized pension plans were not hedging their currency exposure on foreign investments, even though they were large enough to do it cheaply.

– Among those pension plans that did hedge, a common approach was to hedge half the currency exposure.

– Since currency movements are in the often in the opposite direction of stock market movements, a currency hedged portfolio is more risky than unhedged positions in many instances. Check out this post for an explanation on why currency hedged portfolios under perform when stocks and currencies move in opposite directions.

– While currencies can make big moves in either direction, it is unlikely that these moves will be repeated. Therefore, the decision to hedge or not is relatively less important than determining the asset mix of the portfolio.

The report concludes:

It is true that currency hedging could work extremely well if one could time it properly so as to put the hedge on when our dollar is weak, and then take it off later. However, as Alan Greenspan put it, “forecasting exchange rates has a success rate no better than that of forecasting the outcome of a coin toss”. Our dollar looks a little overvalued on some economic measures but we also recognize that this can persist for an extended period of time. Until such time as the Canadian dollar looks severely undervalued, hedging away foreign currency exposure may do more harm than good.

This article has 11 comments

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  2. Why would anyone quote Alan Greenspan for anything anymore?

    The more time that passes, his true lack of financial knowledge is exposed. I wouldn’t trust his saying’s or advice on getting change for a dollar.

  3. @Paul: Agree that Greenspan’s reputation is tarnished. But I do think that he was spot on in this quote.

  4. Yes you of course are correct, I just can’t help myself sometimes to take a shot a him and a small group of people from his era when I can. Millions of people have gone into financial hardship, because of banks lobbying a some high placed people in the government to change a few very important regulatory rules. Mr. Greenspan was either clueless or deliberately supported such changes. I find it difficult to accept that he is still asked for his opinions even today.

    Maybe a topic for another day? Sorry to run off with your topic in a completely wrong direction.

  5. Greenspan was considered a hero during his tenure. It’s only in hindsight we can see how wrong he was. It’s complicated to run a central bank, and it took a long time to expose errors. That said, in hind sight, it appears he made mistakes.

    This is a good post, CC, I really liked this one and yesterday’s about Trahair. If hedging actually worked well, without so much tracking error, it might be worthwhile. However, the article you cited also gives plenty of reasons to avoid it. I especially liked the point about moves happening once and then not being repeated. It is true that the C$ was once worth U$0.67 and is now worth U$1.00, but that doesn’t mean we will someday be at U$1.33.

    Again, good post CC. Thanks for introducing me to new ideas.

  6. It’s worth noting (and sorry if I’m repeating myself – I think I said it somewhere before) that, apart from speculating / taking bets on how the dollar will evolve, currency hedging your portfolio only makes sense to the extent your future use of your nest egg will be in Canadian dollars!

    When I retire early, apart from living expenses, I aim to travel. The costs of that have nothing to do with the Canadian dollar. And a lot of my Canadian expenses – e.g. replacement durable goods, entertainment spend, etc – will significantly track US dollar anyway.

    My portfolio is biased to Canadian exposure and Canadian dollar, but I see little reason to even consider hedging the foreign exposure in my portfolio since I think the foreign exposure in my future expenses will be more than that. It’s what financial institutions would call asset-liability management. When the Canadian dollar is going up, I’m happy that my overweight in Canadian markets makes my overall portfolio worth more in “global units” rather than unhappy that my US ETFs, converted to Cd$, appear to have lost value.

    • @Houska: I think the point is worth reiterating. An investor who plans to spend a lot of time in Europe (for instance) is fully justified in holding unhedged positions in European stocks. I guess this point goes to show that all investing should first start with answering the question: What are the goals of this portfolio?

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  8. CC’s cited report focuses on the SP500 in the US. The US currency is special case, and the “currencies and stocks move in opposite directions” argument does not hold in Canada (from the eyes of a non-Canadian investor), Australia, Brazil and most other markets (exclude Switzerland, USA and Japan).

    CC is spot on saying you must know what your portfolio goals are before you make an investment decision. The hedging decision whether you want exposure to the currency. We invest in SP500 and other international markets for diversification purposes, to access specific stocks and sectors poorly represented or unavailable in Canada, and/or to participate in the anticipated superior growth of a foreign market.
    For a Canadian who plans to retire in Canada, an FX hedge is prudent risk management.

    An unhedged investor in US securities lost significant returns as the CAD appreciated from 1.65 to 0.90 from 2002 to 2007 (for SP500, a difference of a 6% return vs 67% if hedged), but that same investor received a currency boost of over 35% as Lehman Brothers crashed and the CAD went from 0.90 to 1.30, but has again suffered since 2009 as we have returned from 1.30 to 1.00.
    A hedged investor would have fared the opposite.

    @Houska – your comment is quite insightful. It would be a smart exercise to determine the “foreign component” in the pricing of the basket of goods we would expect to consume as retirees. Possibly broken up into discretionary (TV’s), non-discretionary (Gas), and luxury (boat) buckets.

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