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Inside the Market How some Canadian ETF investors got clipped last year by using hedging

The book on protecting your U.S.-stock returns against currency fluctuations is that a hands-off approach is best if you plan to stay invested for 10 or more years.

But as the past year has shown, the short-term differences between owning a hedged U.S. equity ETF and an unhedged fund can be large. The S&P 500 index had a weak year in 2018, losing 4.4 per cent on a total-return basis. That’s by and large your result if you own an exchange-traded fund that tracks the S&P 500 and uses hedging to limit the impact of currency fluctuations on returns to investors.

An unhedged U.S. equity ETF, with returns translated into Canadian dollars, made 4.2 per cent last year. Quite the difference, right? A fairly good gain versus a fairly annoying loss. Tempted to base your hedging strategy for 2019 on what happened in 2018? Careful, now. In early 2019, the Canadian dollar has made up some ground on its U.S. counterpart. If this keeps up, hedged U.S. equity ETFs will outperform.

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The past year highlights how there can be big gaps between the returns from hedged and unhedged U.S. equity funds in the short term. But what if you measure over a longer period – how significant a gap is there? The annualized 10-year return for the S&P in U.S. dollars to Dec. 31 was 13.1 per cent, while the Canadian-dollar return was 14.3 per cent. Over 20 years, the S&P 500 made 5.6 per cent in U.S. dollars and 5 per cent in Canadian dollars.

These numbers suggest the conventional thinking about hedging is correct – it doesn’t have a large impact on returns over 10 or more years. Hedging can have a big impact on shorter-term returns, but it’s not easy to correctly anticipate what the Canadian dollar will do. Guess wrong and you could have ended up losing 4 per cent or so last year instead of making 4 per cent.

Investing with a time horizon of less than 10 years? The easiest solution for your U.S. equity ETFs is to divide your money evenly into hedged and unhedged U.S. funds. This will set your mind at ease. Regardless of what our dollar does, half your U.S. equity holdings are positioned perfectly.

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