Currencies — to hedge or not to hedge
A Canadian expert looks at the pros and cons of hedging against currency swings and reckons the best idea may be to invest at home.
The headlines are full of the ebb and flow of currencies, be it loonies, greenbacks or yuans.
The biggest story in world currencies, of course, has been the weakness of the U.S. dollar.
It has long been the king of currencies. Yet when it rallied from its sickbed yesterday, there was general surprise.
In the face of all these money movements, one Canadian expert has a question.
“Should one hedge U.S. and other foreign investments or leave them unhedged?” asks Mr. Larry MacDonald in Investor's Digest of Canada.
He is not talking about the speculator’s poker game of trading in and out of currencies, but of shoring up your investments so that currency fluctuations don’t undermine their value.
Mr. MacDonald spells out the pros and cons of hedging for Canadian investors. In the end, he says, the best hedge against currency swings may simply be to invest in Canada.
Not a yawning gap
The recent surge of the Canadian dollar has put currency hedging on the front burner for many, says Mr. MacDonald.
Those who don’t hedge “believe that currency fluctuations tend to average out over the long run,” he explains. Exchange rates move through long cycles and return to a mean, they say. Therefore the costs of hedging aren’t worth it if you’re a long-term investor.
And there are a few studies that bear this out. Mr. Lee Thomas reported that between 1975 and 1988, U.S. citizens investing in six foreign currencies had hedged returns of 16.4 per cent and unhedged returns of 16.5 per cent. Not exactly a yawning gap.
End of argument? Not for the hedgers.
Fat tail risk
Those who prefer to hedge their investments agree that in the long run currency fluctuations may break even. But, they argue, what if funds are required before the break-even period? You lose.
There is also the danger of “fat tail” risk. This meaty term signifies an investment whose returns are well off the expected mean. In this case, it refers to a currency that goes into long-term decline, and so will not conveniently average out over time.
“Latin American currencies were once notorious for this,” says Mr. MacDonald. But today the “fat tail” candidate that worries most people is farther north in the Americas.
“The U.S. dollar may well avoid such a fate given its central role in the world economy, but many articles and books nevertheless have been written warning that accumulating financial and trade imbalances may some day result in a currency crisis or flight from the U.S. dollar.”
Upper and lower boundaries
Some Canadians think it’s OK to hedge, says this analyst, but not necessary to pay the costs of hedging indefinitely.
“They will go to a hedged position when the loonie is near its lower historical boundary and go to an unhedged position when it is above its mean exchange rate or near its upper historical boundary.”
Thus, an investor would not put a hedge under his investments when the loonie is in the US$1.00 to $1.05 exchange rate, because that is when the probability of depreciation for the Canadian dollar is highest.
And when the loonie is going down? One investor Mr. MacDonald knows turned to oil. He used the PowerShares Double Short Oil ETF (NYSE-DTO) as a hedge while the Canadian dollar declined in 2008.
Full value for your loonie
The dilemma is this. Hedging can protect you against currency fluctuations, but you have to pay extra to get into a hedged position. Not hedging saves you money, but leaves you open to losses when currencies clash. A mixture of the two has its own costs and uncertainties.
The solution, Mr. MacDonald suggests, may be to avoid foreign diversification. “This would especially apply if one is intending to spend his savings and returns in Canada.” You get full value for your loonie, no matter what it’s worth in Seattle, Paris or Bermuda.
On the other hand, the Toronto Stock Exchange, heavy on financial and resource stocks, is not considered a model of diversification either.
“Nevertheless,” says the analyst, “studies of the historical return on Canadian stocks show that they have been comparable to returns in other countries.”
The Canadian banks are “cartel-like” and strong financially, as was shown at the height of the financial crisis last year. Regulations keep foreign competition away, and the dividends are good.
It also seems reasonable that demand in China and elsewhere will keep demand for Canadian commodities up, the analyst says. This should buoy up the Canadian economy and the loonie. That is, “the Canadian investor’s purchasing power grows in relation to goods and services in other countries.”
The easy way to invest in Canada, Mr. MacDonald tells his Investor's Digest of Canada readers, is through an exchange-traded fund like iShares CDN S&P/TSX Capped Composite Index Fund (TSX-XIC).
You have plenty of choice. You may decide to hedge all of the time, none of the time or some of the time. Or you may just stay at home with your investments and let the loonies fall where they may.
|
E-mail this article
Printer-Friendly
