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I want to buy an exchange-traded fund, in Canadian dollars on the Toronto Stock Exchange, that invests in the S&P 500. But I don’t know if I should choose a currency-hedged or non-hedged version. What do you suggest?

The purpose of currency hedging is to neutralize the impact that exchange-rate fluctuations have on your returns. In theory, if your ETF is perfectly hedged, it should achieve the same return – before taxes and fees – of the underlying S&P 500 index, regardless of whether the Canadian dollar rises, falls, or holds steady against the U.S. dollar.

But in practice, hedging doesn’t deliver perfect results. That’s because hedging – which involves buying currency forward contracts to lock in an exchange rate, typically for a month at a time – isn’t exact, and also because it adds to an ETF’s costs.

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Consider the currency-hedged iShares Core S&P 500 Index ETF (XSP). For the five years ended Sept. 30, XSP produced an annualized total return – assuming all dividends had been reinvested – of 12.3 per cent. Over the same period, the S&P 500 returned about 14.1 per cent. So XSP trailed the index by 1.8 percentage points annually.

XSP’s underperformance can’t be explained by its management expense ratio, which is just 0.1 per cent, but reflects the imperfections and added costs of hedging.

What’s more, XSP lagged the non-hedged version of the iShares Core S&P 500 Index ETF (XUS), which returned 13.6 per cent annually over the same five-year period. It’s worth noting that the Canadian dollar finished the period virtually unchanged from where it began, so it’s no surprise that hedging didn’t add any value in this case. Hedging can be even more costly when the loonie is falling, because it blunts the favourable currency impact that would otherwise increase the value of U.S. assets in Canadian dollars.

That’s not to say hedging is always a bad idea. The one scenario where it can improve relative returns is when the loonie is rallying against the U.S. dollar.

For example, say you bought the non-hedged BMO S&P 500 Index ETF (ZSP) at the end of 2015 when the Canadian dollar was worth about 72 US cents, and then sold ZSP in mid-September, 2017, when the loonie had climbed to more than 82 US cents. Your total return for the period – including the stiff headwind from the rising Canadian dollar – would have been about 10.4 per cent.

That’s not bad. But if you had instead bought the currency-hedged version of the BMO S&P 500 Index ETF (ZUE) – and neutralized the impact of the loonie’s rise – your return would have been 24.7 per cent. Hedging worked like a charm in that case.

Identifying when hedging was desirable in the past is easy. But knowing when it will be advantageous in the future is virtually impossible, because currency movements are notoriously unpredictable. Over the past 10 years, the Canadian dollar has traded as low as about 68 US cents, and as high as about US$1.06, with an average of 85 US cents. Where it goes from its current value, approximately 76 US cents, is anyone’s guess.

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If you are uncomfortable with even the slightest bit of currency-related volatility – and you are prepared to accept the imprecision and additional costs of hedging – then a hedged ETF may be the way to go. But if you are prepared to surf the currency waves, an unhedged ETF may be a better choice.

Apart from lower costs, unhedged ETFs offer another benefit: portfolio diversification. As we saw during the financial crisis of 2008 and 2009, for example, the U.S. dollar is seen as a safe haven in times of global turmoil. Allocating a portion of your portfolio to non-hedged U.S. assets may provide a cushion in troubled times – a benefit that will be lost with a hedged ETF.

If you still can’t decide, you could always compromise by investing half of your S&P 500 allocation in a hedged ETF, and the other half in a non-hedged ETF. That way, whether the loonie rises or falls, you can pat yourself on the back for having made the right decision for half of your money.

Finally, perhaps even more important than the type of ETF you choose is your behaviour as an investor. Index ETFs are meant to be passive vehicles that give you exposure to a broad selection of companies. Buying and holding for years – and participating in the growing earnings, share prices and dividends of these companies – is the surest way to build wealth. So, regardless of whether you opt for a hedged or non-hedged ETF, treat it as a long-term commitment.

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.

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