To hedge or not to hedge, that is the question facing Canadian investors venturing into the U.S. market.
The Canadian dollar's dramatic surge against the U.S. greenback illustrates the damage currency swings can inflict on a portfolio. The S&P 500 is down about 27 per cent over the past decade, which is bad enough. But Canadian investors who didn't hedge their currency exposure suffered a 48-per-cent loss.
On the other hand, with the Canadian dollar now trading within a few pennies of parity with its U.S. counterpart, some investors say the argument in favour of hedging isn't nearly as strong as it once was, because the loonie has already had a huge move. Indeed, if the Canadian dollar were to fall, unhedged investors would be the big winners.
What's an investor to do? It all depends on your tolerance for risk and your view of where the dollar will head next.
Because currencies are notoriously unpredictable, the safest approach is to hedge exposure to the U.S. dollar, some experts say.
"If you want absolute predictability then you should always hedge," said Aaron Fennell, senior market strategist and portfolio manager at Lind-Waldock, a commodity futures broker that provides currency-hedging services to clients.
For a commission of less than $100 per contract, Lind-Waldock will purchase currency futures in increments as small as $10,000 on the Chicago Mercantile Exchange, allowing clients to hedge their U.S. dollar assets. Contracts are also available in increments of $100,000 for a similar commission. Contracts are usually "rolled" every three months, so the costs of hedging can add up, although clients who do their own hedging through an online account with Lind-Waldock get a discount.
"We literally do this every day for customers. We deal mostly with high-net-worth speculators," he said.
For less sophisticated investors, a much easier way to hedge is to buy a currency-neutral version of mutual funds or exchange-traded funds that invests in the U.S. market. Examples of ETFs with built-in currency hedging include the iShares S&P 500 Index Fund , Claymore U.S. Fundamental Index ETF and the BMO Dow Jones Industrial Average ETF .
Warning: Hedged ETFs will not track their underlying indexes perfectly. That's partly because hedging isn't an exact science, particularly in volatile markets, and also because of the costs involved.
"Essentially you're buying insurance, and there's always going to be a cost," said Oliver McMahon, director of product management for iShares ETFs at BlackRock Canada. For instance, he estimates that hedging adds about one basis point per month - or about 0.12 percentage points annually - over and above XSP's management fee of 0.24 per cent.
From his perspective, the cost is well worth it for investors seeking peace of mind.
"It's very hard for a small investor to [hedge their portfolio]cost-effectively and efficiently. A currency-hedged ETF is only going to cost you a handful of basis points more than an unhedged one," he said.
Still, not everyone is convinced that hedging is necessary given the loonie's lofty value.
"It depends on when you're doing it," said Murray Leith, vice-president and director of research at Odlum Brown in Vancouver. "With the dollar within spitting distance of par, I think there is a cost associated with hedging and I don't think there's an offsetting benefit."
Based on purchasing power parity - that is, the exchange rate at which the currencies would buy similar amounts of goods in both countries - the Canadian dollar should be trading somewhere between 80 cents (U.S.) and 85 cents, he said. That's well below its current level of about 97 cents.
"I think we're above fair value and the bigger risk is that it probably goes back down," he said.
Still, arguments like that don't convince Larry Sarbit, who manages the IA Clarington Sarbit U.S. Equity Fund. Because his fund invests exclusively in the U.S. market, he can't afford to take a chance that the Canadian dollar will move against him. As a result, the fund is always fully hedged.
Predicting currency moves "is not something that I trust anybody can get correct," he said. "It can wipe out your returns, so why would you put yourself in that situation? If I remove my hedges I guarantee [the currency]will do something awful to me. That much I know."