Q&A: Currency Hedging

A reader doesn’t understand the concept of currency hedging or how to use it. Here, Gordon Pape explains.

Q – I’ve been reading about currency hedging but I’m not much the wiser for it. Can you help? – Ian M.

A – The basic purpose of hedged ETFs and mutual funds is to remove currency risk from the investing equation. All transactions are translated back into Canadian dollars so you don’t need to worry if the euro, yen, or U.S. dollar is rising or falling against the loonie. Your only concern is the performance of the securities held within the fund.

All stock and bond investments entail market risk. If the underlying securities are denominated in a foreign currency, you have to factor in exchange risk as well.

Depending on how currencies move, that can have a huge effect on your bottom line. For example, during the years when our dollar was steadily rising against the U.S. greenback, profits made by Canadians on American stocks were deeply eroded by currency losses. A hedged fund would have shielded investors against those.

Conversely, over the past year we’ve seen the loonie fall sharply against the U.S. dollar. Anyone who held stocks or bonds denominated in greenbacks (or who simply had a U.S. dollar bank account) could have ended up with more profit from the move in exchange rates than from the gains in the underlying securities.

So what should you do in these circumstances? Conservative investors should always choose hedged funds in my opinion because they eliminate a key risk factor. More aggressive investors, who feel they have a good sense of currency fluctuations, may wish to choose unhedged funds to increase profit potential. But in that case, be prepared to switch into hedged versions at any time. Currency markets are extremely volatile these days and trend lines can shift quickly. Going unhedged exposes you to greater dangers, so stay on top of the currency situation at all times. – G.P.

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