One of the big losing moves in investing over the past several years has been to own U.S. equity ETFs and mutual funds with currency hedging.
But weakness in the U.S. dollar compared to our Canadian buck changes things. For now, hedged U.S. equity funds are outperforming.
Investor skepticism about currency hedged exchange-traded funds is understandable, given the results produced in the past few years. “However, the recent performance of these ETFs has proved their ability to reduce return volatility and withstand even drastic currency shifts in the market,” National Bank Financial said in a recent note to investors.
Currency hedging is the use of financial instruments called derivatives to mute the effects of currency fluctuations in a way that leaves investors with the return of the underlying stocks in an exchange-traded fund or mutual fund. The cost of owning hedged and unhedged funds is pretty much identical, but there can be huge differences in performance.
This is particularly true for U.S. equity funds, thanks to the long decline of the Canadian dollar against its U.S. counterpart. Without hedging, a falling dollar adds to your returns in U.S. dollars and a rising dollar undermines returns.
The S&P 500 with hedging to screen out fluctuations in the Canadian dollars produced an average annual total return of 10.9 per cent for the three years to April 30. The unhedged S&P 500 – where you get the benefit of index returns plus a falling Canadian dollar – averaged 14.6 per cent.
Until recently, it seemed pointless to raise the point that hedged U.S. equity funds do better in periods where the Canadian dollar is rising against its U.S. counterpart. Now, this is actually happening as the global trade war instigated by the U.S. government undermines confidence in the once impregnable U.S. dollar. At the same time, the results of the April 28 federal election have added a little momentum to the Canadian dollar, which traded at early this week around 71.2.5 US cents. Earlier in the year, the loonie traded below 69 US cents.
You can see the results of the Canadian dollar’s recent strength in S&P 500 returns. The hedged version of the index was down about 3.9 per cent for the year through May 8, while the unhedged version lost 6.6 per cent.
The Canadian dollar has been in a long-term decline from 82 US cents since spring 2021, with only brief rallies. The recent strength of our buck may yet fade, but for now it looks to be rallying nicely off trade war lows. The longer the U.S. administration leaves global investors uncertain about its economic policies, the more potential there is for the Canadian dollar to keep rising. Hedged U.S. equity funds help you profit from this trend.
