Welcome back to our series on currency-hedged equity ETFs. In our last post, BlackRock’s Steven Leong and I described how and why these securities work, and touched on when they might appeal to an investor. We also pointed out that we’re focusing on equity ETFs in this series. Given the stabilizing role they’re supposed to play in your portfolio, all your bond ETFs should probably be 100% hedged without further ado.

Then we left you with a cliff-hanger: Compared with the rest of the developed world, we Canadians must consider currency hedging from an unusual risk-and-return perspective. Our unique position also explains why we use unhedged equity funds in our CPM model portfolios.




Currency Hedging Risks and Returns

First, it helps to know which foreign currencies you’re actually exposed to in your U.S. and international equity ETFs. If we take the June 30th, 2020 country weights from the popular iShares and Vanguard asset allocation ETFs, we find that the U.S. dollar is by far a Canadian index investor’s largest foreign currency exposure, making up around 65% of their developed foreign currency weight. The euro and Japanese yen contribute another 20% to the currency mix. The pound sterling, Swiss franc and Australian dollar combo add up to another 10% of your total foreign currency exposure, with various other currencies making up your remaining 5%.


U.S. dollar64.3%65.9%
Japanese yen9.4%8.5%
Pound sterling5.2%4.8%
Swiss franc3.4%3.1%
Australian dollar2.5%2.3%

Source: BlackRock Canada MSCI and FTSE index fact sheets as of June 30, 2020


Many Canadian investors think of the U.S. dollar and Japanese yen as their “safe haven” currencies. They have historically been contracyclical, meaning they tend to rise as world stock markets fall, and vice-versa.

This is generally good news for unhedged Canadian investors seeking effective diversification, as these two currencies represent nearly 75% of our U.S. and international equity currency exposure.

As world stocks rise in value, the U.S. dollar and Japanese yen tend to depreciate against other currencies like the Canadian dollar. This reduces a Canadian investor’s returns. (Remember, foreign currency depreciation is a bad thing for an unhedged Canadian investor.)

When world stocks fall in value, the U.S. dollar and Japanese yen tend to appreciate, dampening the losses for a Canadian investor by providing some currency gains.

So, the highs are not as high, but the lows are not as low. This would suggest that these sorts of safe-haven currencies are expected to lower portfolio risk for an unhedged Canadian investor. In fact, the U.S. dollar and Japanese yen have historically been uncorrelated to world stock markets, and even negatively correlated, especially since the Global Financial Crisis.

In contrast, the Canadian dollar has historically been procyclical. It often strengthens against other currencies when world stock markets rise, and weakens when world stock markets fall. You could say that the Canadian dollar has historically been positively correlated to world stock markets on average. This is largely due to the make-up of the Canadian stock market. We are a large exporter of natural resources, and these companies tend to prosper during periods of favourable global economic growth.



The Canadian Hedging Plot Thickens

If you’ve followed all this so far, it brings us to this important understanding:

As a Canadian, if you hedge away your foreign currency exposure, you’re effectively selling “safer” currencies (largely the U.S. dollar and Japanese yen).

In other words, at least in theory, Canadian investors are expected to increase their portfolio risk if they hedge the foreign currency exposures in their equity ETFs.

Then again, theory isn’t always reality. In real life, correlations between currencies and world stock markets are not static. They fluctuate over time, making it impossible to predict whether hedging your exposure to foreign currencies will reduce or increase foreign equity volatility during any particular period.

During the 50-year period from January 1970 – December 2019, hedging a Canadian investor’s foreign currency exposure back to Canadian dollars reduced volatility in about 48% of the rolling 10-year periods. Of course, simple math tells us hedging increased volatility in about 52% of periods. However, most of the risk reduction from hedging came during the first half of the period, with the increased volatility showing up more toward the tail end.



What happens when we crunch all the highs and lows together, to determine an average effect? On average, hedging increased stock market volatility for a Canadian investor.

Canadian Currency Volatility: We’re Number One

It’s significant to note, if there’s ever a contest for which developed country’s currency generates the most volatility when you hedge against it … we “win”! In other words, the phenomenon we’re describing here appears to be specific to Canadian investors.

In a 2011 research bulletin, MSCI analyzed 13 developed countries from 1970–2009. They found investor hedging resulted in lower volatility in 12 of the 13 countries. Canada was the only outlier with higher volatility from hedging. Specifically, other countries’ average volatility reductions ranged from an average –5.4% reduction in Australia, to an average –18.7% in Switzerland. In marked contrast, Canada’s volatility increased by an average +2.3%.



In a 2014 report, Vanguard took this analysis to the next level, by determining the percentage of rolling 10-year time periods between 1971–2013 when hedging significantly reduced volatility. They found no rolling 10-year periods when hedging foreign currencies back to the Canadian dollar reduced a Canadian investor’s volatility at a significance level beyond 0.05.

In contrast, all other regions experienced rolling ten-year periods where hedging significantly reduced the volatility for their investors, ranging from 35.9% of periods for Australian investors to 89.9% of periods for Japanese investors.



Asset Allocations and Retiree Considerations

So there you have it. Besides producing the world’s best hockey players, Canada appears to be the only developed country whose investors cannot expect to reduce their overall equity portfolio risk by hedging away foreign currency exposure.

Then again, to add to the intrigue, there are some exceptions to the exceptions for Canadian investors. For one, your portfolio’s asset allocation plays a role we’ve not yet mentioned.

So far, we’ve been discussing all-equity portfolios. Most investors also allocate a portion of their portfolio to safer bonds. Depending on your asset mix, this can change the results. And yes, retirees, you should take special note here.

Let’s compare asset allocations using data from TD’s Index Mutual Funds, with equity allocations split evenly among Canadian, U.S., and international equities. I’ve used the TD index fund return data, as these funds have been around longer than currency-hedged ETFs. They also have hedged and unhedged versions of their U.S. and international equity index funds.

Over the past 20 years ending December 31, 2019, higher equity allocations proved more volatile when investing in currency-hedged funds, which is what we would expect. But as the portfolio allocation to equities drops, so does the difference in volatility (or risk) for the unhedged vs. hedged portfolios.

This means, a very conservative Canadian investor with a 30/70 stock/bond asset mix would have experienced very little volatility reduction by remaining unhedged. A very aggressive Canadian investor with a 90/10 stock/bond asset mix would have experienced a noticeable reduction in their portfolio risk by remaining unhedged.

This has some important portfolio management implications for Canadian retirees. If you adjust to a more conservative asset allocation as your investment horizon decreases in retirement, you may want to also consider gradually switching your unhedged foreign equity ETFs to currency-hedged versions. You’re no longer expected to reduce portfolio volatility as much by holding unhedged foreign equity ETFs. In fact, for extremely conservative portfolios, currency-hedged ETFs could potentially reduce rather than increase a portfolio’s volatility.



Doubling Down During Market Downturns

From a behavioural perspective, foreign currencies can also come to the rescue here in Canada when we need them most: during severe market downturns. Let’s check out how currency-hedged and unhedged ETFs held up during the Global Financial Crisis and the current Global Pandemic (at least so far).

The worst period of the Global Financial Crisis was the 17 months from October 9, 2007 – March 9, 2009. During that time, currency-hedged U.S. and international equity ETFs lost 60% of their value in Canadian dollar terms. Unhedged Canadian investors’ returns were noticeably better, losing around 42% and 49%, respectively, on their U.S. and international equity ETFs.



This was mainly due to the 32% appreciation of the U.S. dollar, and 57% appreciation of the Japanese yen, relative to the Canadian dollar. Other foreign currencies also pitched in to dig us out of this mess, with the euro and Swiss franc appreciating against the loonie by 18% and 35%, respectively.

In other words, it was a bad time for Canadian investors, but even worse for Canadian currency-hedged investors.



The most recent 2020 stock market crisis followed a similar theme. Between February 19 – March 23, 2020, the U.S. dollar, Japanese yen, euro, and Swiss franc, all appreciated against the Canadian dollar by around 9-10%.



In turn, currency-hedged U.S. and international equity ETFs underperformed their unhedged counterparts. BlackRock’s currency-hedged iShares Core S&P U.S. Total Market Index ETF (XUH), lost 37% of its value, while its unhedged cousin, XUU, lost only around 28.5%. As we’ve mentioned in this past CPM post, XUU’s better performance was a result of the U.S. dollar appreciating by 9.5%, relative to the Canadian dollar.

Vanguard experienced similar results. The currency-hedged Vanguard U.S. Total Market Index ETF (VUS), lost 37% of its value, while its unhedged counterpart, VUN, only lost around 28.6%. (As BlackRock’s Steven Leong discussed in our last post, neither VUS nor XUH were able to match the 35% loss from the U.S. stock market over the same period, due to the imperfect nature of the currency-hedging process.)



In developed stock markets outside of North America, the currency-hedged iShares Core MSCI EAFE IMI Index ETF (XFH) lost around 31% of its value, while its unhedged counterpart, XEF, lost only 27%.

Ditto with Vanguard. Its currency-hedged FTSE Developed All Cap ex North America Index ETF (VI) also lost around 31% of its value, while its unhedged counterpart, VIU, lost only 27%.



Going Unhedged Without Going Unhinged

Whew, that was a lot of data, all suggesting one thing: For Canadian investors, unhedged global equity ETFs have tended to shine the strongest during global markets’ darkest days. By offsetting weaker market returns with continued exposure to contracyclical currencies, they have minimized the volatility of the ride.

Your take-away? Especially if your risk tolerance isn’t the best in the world, having this volatility-smoothing influence in your portfolio may help you stay the course, especially during significant market downturns.

This offers a perfect segue to two more questions we’d like to address before we wrap our series on currency-hedged equity ETFs:

  1. What about returns? We’ve shown how hedging, or the lack thereof, impacts volatility. But how much does the hedging decision actually influence your expected returns?
  2. How about timing your hedges? Can a Canadian investor have the best of both worlds by cleverly shifting between hedged and unhedged positions based on market conditions?

The short answers are: Not so much, and probably not. These will be perfect points to elaborate on in our next post.