In recent weeks, the financial world has seen significant shifts. As of October 18, the U.S. dollar (USD), often viewed as a "flight to safety" asset, has experienced a noteworthy surge.
Factors contributing to this trend include the ongoing conflict between Israel and Hamas, a challenging market atmosphere in September, and the looming cloud of uncertainty over the Federal Reserve's impending rate decisions.
Consequently, the USD dollar (USD) has risen noticeably against the Canadian dollar (CAD), with the current rate hovering around 1.37 USD/CAD.
Given this backdrop, Canadian investors might be pondering a crucial question: Is now the moment to transition to currency-hedged ETFs, anticipating a potential reversal in the current trend?
Why consider currency hedging?
When Canadian investors look towards the U.S. market, two common S&P 500 ETFs often come to mind: The Vanguard S&P 500 (TSX:VFV) (VFV) and its counterpart, the Vanguard S&P 500 CAD hedged (TSX:VSP) (VSP).
However, the way they respond to currency fluctuations can be significantly different, which is crucial for investors to understand.
VFV is non-currency hedged. What this means is that while its returns are primarily determined by the performance of the underlying S&P 500 index, they are also influenced by the FX rates between the USD/CAD pair. The stocks in the S&P 500 are traded in USD. Therefore:
- If the USD appreciates: Alongside any gains from the S&P 500, Canadian investors would also benefit from the increased value of the USD relative to CAD. In essence, a strengthening USD boosts VFV's returns when converted back to CAD.
- If the CAD appreciates: Conversely, if the Canadian dollar strengthens against the USD, this would dampen the returns of VFV for Canadian investors. This is because the underlying U.S. assets would now be worth fewer Canadian dollars.
On the other hand, to combat the unpredictability of currency movements, VSP employs currency derivatives. These are tools that essentially "hedge" or protect against currency risk.
- If the USD appreciates: The hedging mechanism within VSP would try to neutralize the currency gain, meaning the returns of VSP would primarily reflect the S&P 500's performance, without the added boost from the rising USD.
- If the CAD appreciates: Similarly, if the CAD strengthens, the hedging will aim to counteract the potential drag on returns from the weakening USD. Again, the goal is to mirror the S&P 500's performance more closely without the interference of currency movements.
Now, VFV and VSP aren't the only pair of ETFs on the market with this dynamic. Dividend investors may prefer the CI WisdomTree U.S. Quality Dividend Growth Index ETF (DGR) and the CI WisdomTree U.S. Quality Dividend Growth Index ETF (DGR.B), which are hedged and non-hedged respectively.
Should you consider currency hedged ETFs?
If you're in it for the long haul, consistently hedging against currency risks might end up doing you more harm than good.
Currency fluctuations can be quite volatile in the short term, but they tend to even out over longer periods. For long-term investors, currency movements often become a blip on the radar over decades.
Moreover, currency hedging isn't without its costs. As seen with VSP's use of currency derivatives, there's a tangible price to pay. Over time, these costs can eat into your returns, acting as a drag on the ETF's performance compared to a non-hedged version.
Moreover, given that the USD tends to appreciate during market crises, having exposure to it can act as a cushion, dampening the volatility and drawdowns in your international investments.
Reacting to the current state of the USD or any other currency pair, like switching to a currency-hedged ETF because of recent spikes, is essentially an attempt at market timing.
If one could consistently predict FX movements with accuracy, trading forex would be the primary recommendation. But the reality is that even seasoned forex traders find it challenging to predict short-term currency movements consistently.
Therefore, such a reactionary approach is not advisable. Trying to predict the short-term movements of currency pairs is fraught with unpredictability.
However, if you have a low risk tolerance combined with a shorter investment horizon – for example, if you're nearing retirement – a currency-hedged ETF might be worth considering.
In such scenarios, you might prioritize stability and desire returns that closely track the index, without the added layer of currency risk. Currency-hedged funds can provide a layer of protection against the vagaries of short-term currency fluctuations.
This content was originally published by our partners at the Canadian ETF Marketplace.