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Hedging Your Currency Risk Exposure

hedge.jpg

BY: STEVE HAWKINS, PRESIDENT AND CEO, HORIZONS ETFS

Last year, many Canadian investors were punished for hedging the United States dollar (USD) risk exposure in their portfolios. However, we’re witnessing a reverse trend so far this year, where hedgers are seeing better returns, as illustrated in the chart below.

S&P 500 Total Return Index vs. the Canadian Dollar (CAD) Hedged Version of the S&P 500 Total Return Index
chart1.PNG

Source: Morningstar Direct as at July 31, 2016.

The USD/CAD relationship is an extremely important one for Canadian investors. The USD has historically been inversely correlated to Canadian equity returns. If there’s a shake-up in energy prices or economic issues with the Canadian dollar, you can expect the USD to appreciate vs. the CAD, significantly eroding Canadian equity returns.

For this reason, investors in U.S. equities (which make up the largest swath of international equities in Canadian portfolios) should probably un-hedge their exposure because it diversifies their portfolio. As well, hedging is expensive and not a very reliable source of returns. However, if you’re convinced that the Canadian dollar will generate better returns than the foreign currency being invested in, then hedging makes sense.

The odd mechanics of ETF hedging

In order to hedge the Canadian currency, ETFs must use currency forwards. Even on an extremely liquid futures contract like USD/CAD, the mechanics of buying and selling currency forwards creates additional costs.

As well, these ETFs will have a higher degree of tracking error — not only to the locally denominated index — but sometimes to the index they are tracking. The index methodology of CAD-hedged indexes is almost always set on a monthly basis at an end-of-month currency spot price. Since currencies don’t stay static throughout the month, there can be significant deviation between the currency return reported by the index and what’s actually achieved by the ETF. This underscores that investors should avoid hedging strategies unless there is significant currency risk in the CAD/local currency relationship.

Doing it yourself with currency ETFs

If you’re of the view that the USD/CAD relation could change dramatically, you can simply buy a currency ETF like the Horizons U.S. Dollar Currency ETF (DLR) or the Horizons Canadian Dollar Currency ETF (CAN).You can use these ETFs to get direct exposure to either the USD reflected in Canadian dollars or to CAD reflected in U.S. dollars. These types of ETFs are ideal if you have a fixed asset allocation that you don’t want to mess around with.

Delegate your hedging with actively managed ETFs

Given the excess returns that can be generated through currencies, we’re seeing a lot of strategies that actively manage currency exposure. Recently, we launched an actively managed currency ETF strategy, the Horizons Global Currency Opportunities ETF (HGC). It invests in a universe of 32 currencies with the express purpose of outperforming the Canadian dollar. Most successful global strategies today have dynamic or active currency management. For example, our Horizons Active Global Dividend ETF (HAZ) has generated approximately 5% additional returns over the last year by tactically hedging, when necessary, its international equity exposure. Similarly, the Horizons Global Managed Opportunities ETF (HGM) uses currency management as a key driver of its returns.

The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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