Oil, water and loonies

In Canada, the debate on currency hedging seems pretty much settled – at least for ETF purists. Currency hedging introduces additional costs, which undermines the notion of cheap investing, and furthermore adds tracking error. Better to get the raw index return and deal with currency conversion when it’s time to cash out.

But that argument is a bit one-sided. While academic theory suggests that currencies are a wash over time, for most Canadian investors, there are only two stock markets: Toronto and New York.

The currency hedging that really matters, then, involves whether to buy a U.S.-listed ETF, or a Canadian ETF that holds a U.S.-listed ETF, hedged or unhedged. There are costs on either side, and they have to be weighed against convenience. To buy a U.S.-listed ETF incurs a foreign exchange cost. To buy a Canadian ETF may involve some tracking error. A hedged Canadian ETF adds the cost of currency derivatives.

But, as smart-beta investing shows, there are all sorts of factors at work in investing. The simple market-cap weighting model is only one way of building an ETF. Currency, too, is a factor, and it’s Bank of Canada Governor Stephen Poloz who tells us so. “When the world economy is strong, commodity prices rise and our currency tends to float up to facilitate the adjustment of our economy,” he recently told an audience in Drummondville, Quebec.

Americans are far less adamant about currency hedging. ETF.com recently published a piece from Scott Kubie, chief investment strategist of Omaha, Neb.-based CLS Investments. “While investors may be open to higher international allocations, they may not want the overall risk of their portfolio to rise,” he writes. “Fortunately, currency hedging provides the solution. Hedging currency risk has been a very consistent risk reducer. Comparing the risk of the local index (effectively a zero cost hedge index) and the index in dollar terms (the standard benchmark) shows a marked risk differential.”

Currency is a risk and what counts in the end is risk-adjusted returns.