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Should You Currency Hedge Your Portfolio? | Common Sense Investment with Ben Felix - YouTube
Channel: Ben Felix
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This video is in response to a question from
abe on LinkedIN.
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Abe wanted to know if he should hedge the
foreign currency exposure of his equities
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when the Canadian dollar is weak.
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There is no question that investing globally
is beneficial.
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Diversification is the best way to increase
your expected returns while decreasing your
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expected volatility.
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Diversification is, after all, known as the
only free lunch in investing.
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When you decide to own assets all over the
world, you are not just getting exposure to
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foreign companies, but also to foreign currencies.
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I鈥檓 Ben Felix, Associate Portfolio Manager
at PWL Capital.
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In this episode of Common Sense Investing,
I鈥檓 going to help you decide if you should
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currency hedge your portfolio.
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If you own an investment in a country other
than Canada you are exposed to both the fluctuations
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of the price of the asset in its home currency,
and the fluctuations in the currency that
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the asset is priced in.
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For example, if a Canadian investor owns an
S&P 500 index fund giving them exposure to
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500 US stocks, and the S&P 500 is up 10%,
but the US dollar is down 10% relative to
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the Canadian dollar, then the Canadian investor
will have a return of 0%.
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To avoid the impact of currency fluctuations,
some investors choose to hedge their currency
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exposure.
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If our Canadian investor had purchased a hedged
index fund, eliminating their currency exposure,
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they would have captured the full 10% return
of the S&P 500 index without being dragged
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down by the falling US dollar.
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Before I continue, I want to be clear that
I am talking about adding a long-term hedge
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to your portfolio.
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Trying to hedge tactically, by predicting
currency movements, is a form of active management
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which you would expect to increase your risks,
costs, and taxes.
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Now, on with the discussion.
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Multiple research papers have concluded that
the effects of currency hedging on portfolio
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returns are ambiguous.
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In other words, with hedging sometimes you
will win, sometimes you will lose, but there
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is no evidence of a universal right answer, unless you
can predict future currency fluctuations.
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With no clear evidence, and an inability to
predict the future, the currency hedging decision
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stumps many investors.
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The demand for hedging tends to rise and fall
with the volatility of the investor's home
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currency.
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If the Canadian dollar strengthens, investment
returns for Canadian investors who own foreign
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equities will fall, which might make the investors
wish they had hedged their currency exposure.
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While it may seem obvious that a hedge would
have made sense after the fact, hedging at
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the right time is impossible to do consistently.
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In a 2016 essay titled Long-Term Asset Returns,
Dimson, Marsh, and Staunton showed that between
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1900 and 2015 real exchange rates globally
were quite volatile, but did not appear to
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exhibit a long-term upward or downward trend.
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In other words, over the last 115 years currencies
have jumped around a lot in relative value,
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but you would not have been any better off
with exposure to one currency over another.
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This was similarly demonstrated in Meir Statman鈥檚
2004 study of US hedged and unhedged portfolios
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over the 16 year period from 1988 to 2003.
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The study concluded that the realized risk
and return of the hedged and unhedged portfolios
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were nearly identical.
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If there is no expected benefit to hedging
your foreign equities in terms of higher returns
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or lower risk, why would you hedge at all?
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It is always important to remember why we
are investing.
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Most people are investing to fund future consumption,
and most Canadians will consume in mostly
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Canadian dollars.
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Hedging against a portion of currency fluctuations
might help investors capture the equity premium
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globally while limiting the risks to consumption
in their home currency. With that being said..
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It is typically not a good idea to hedge all
of your currency exposure because because
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currency does offer a diversification benefit.
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Well, it seems like we鈥檙e back to square
one, trying to decide whether we should hedge
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or not.
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There is no evidence either way.
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You would not expect a difference in long-term
risk or return from hedging.
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Currency hedging at least a portion of your
equity exposure has the benefit of keeping
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some of your returns in the same currency
as your consumption, but too much hedging
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removes the diversification benefit that currency
has to offer.
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In the absence of an obvious answer, I think
it makes sense to take a common sense approach.
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If you鈥檙e going to hedge, don鈥檛 hedge
all of your currency exposure - I wouldn鈥檛
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hedge more than half of the equity portion
of your portfolio.
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If you don鈥檛 want to hedge, that is ok too.
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Remember that there is no evidence in either
direction.
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Whatever you choose to do, understand that
there will be times when you wish that you
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had done something different.
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If the Canadian dollar rises, you might wish
that you had hedged.
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If it falls, you might wish you were not hedged.
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At those times, the worst thing that you can
do is change what you are doing.
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The best thing that you can do is pick a hedging
strategy and stick with it through good times
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and bad.
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Join me in my next video where I will tell
you if you should invest in high yield bonds.
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My name is Ben Felix of PWL Capital and this
is Common Sense Investing.
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I鈥檒l be talking about a lot more common
sense investing topics in this series, so
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subscribe and click the bell for updates.
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I want these videos to help you to make smarter
investment decisions, so feel free to send
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me any topics that you would like me to cover.
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