Isabela: Have you ever looked at your international ETF and thought, wait, why did it go down when the market over there went up? You might have just met your new “frenemy” .... Currency risk. Today I'm joined by Rachana Bhat, returning guest, to discuss how currency hedging can help smooth out the ride on your portfolio. Welcome back. Rachana. How are you doing?
Rachana: I'm doing great. Thanks for having me back. You know, I like how you started. currency can be that sneaky factor. Quietly moving your returns. Sometimes up, sometimes down. And the challenges. It's not always easy to predict.
Isabela: Exactly. So even when I think I might be making all the right calls, something behind the scenes could actually be playing with that.
Rachana: Exactly. And that's where understanding how currencies work and what you can do about them really matters.
Isabela: Absolutely. So actually, let's start there. What exactly is currency risk.
Rachana: Yeah. So, let's take an example. So, if you live in Canada, most likely you prefer your investments to pay you in Canadian dollars. Correct? But if you buy U.S. dollar assets or international investments, your money rides two roller coasters. The asset that you've invested in. So, it could be the stock market, the bond market or something else.
And it's the exchange rate. Currency risk happens when one currency changes value relative to another currency. So, let's, you know, take an example here. If you are a Canadian investor, you've invested in US dollar ETFs or US stocks for example. Let's keep it easy. let's assume that the US stock goes up by about 10%. however, your US dollar weakens about 10% relative to Canadian dollars.
It means that your return home could actually end up being zero or close to flat. And the logic here is pretty simple, because each of those US dollar assets that have gone up in price in the local market now translates back to fewer Canadian dollars. It's the flip side to which is if Canadian dollar weakens, it's a boost to your investments.
So, when you own or invest in foreign holdings, you quietly hope that, you know, the currency actually weakens a little bit. Your home currency weakens a little bit because it adds to your returns. And as you can see, even if you have done your homework and invested in the right asset in that market, and that investment has gone up locally, currency swings can change what you actually own once everything's converted back.
It's like the tide on the beach. Sometimes it helps you along. Sometimes it pulls you back, but it's always in motion and you need to pay attention to it.
Isabela: I like that the tide is never going to stop moving.
Rachana: Yeah, absolutely.
Isabela: So, it's really important because the same thing goes with currencies. Like they're going to be always moving as well. Yeah. So, what exactly is causing these moves. What's the big picture behind them?
Rachana: Yeah. You know, at a very simple level. Currency moves really boil down to two big forces. One is central banks. What a central bank's doing, meaning interest rate policy. And we know that policy high level is driven by inflation and growth trends in that economy. So, when central banks are raising rates, it tends to be positive for that currency.
So that currency goes up. And the logic is pretty simple. If you reflect as I speak to it, higher rates attract more money, more money equal to more demand for that currency and more demand for that currency means that currency is going to lift higher.
Isabela: That's a nice equation there.
Rachana: Yep.
Isabela: I like that. Okay. And so, what what's the other side of this big picture.
Rachana: Yeah. The other side hand, when central banks are cutting rates, it's actually not good for that currency usually. So, it weakens. And it's the opposite. It's not as appealing to the investors. The second force that I mentioned about is really about the global mood, the whole risk sentiment side of things. So, if investors are feeling uncertain, markets are nervous.
The investors tend to flock to the U.S. dollars. That means it strengthens the US dollar. and currencies like the euro or Canadian dollar can weaken.
Isabela: Perfect. So, it's a mix of two things. That's what central banks are doing and how the investors are feeling. And as we all know, there's quite a bit of psychology when it comes to the markets. So that obviously does present a risk. And what does hedging actually do about this risk.
Rachana: Yeah. So, hedging. Let's go back to the example that I spoke about which was you know, you're if you're a Canadian investor holding foreign assets, then your money's really on two roller coasters. The market itself and the currency. Hedging basically is when you say, you know what, I, I only want to ride one of those. So, I mean, you hedged the currency risk in your portfolio.
You actually stay on the market roller coaster when you step off the currency one. And if I have to say this in very, very simple terms, it means that you're adding protection against currency risk in your portfolio. That means now you earn. Once you hedge your portfolio, you actually exposed to the movement in the local market for the investments that you've made.
But you no longer are affected by, let's say, the Canadian dollar moving up or down against the US dollar.
Isabela: That's a great way of putting it. And it feels like it's just one less thing that investors essentially have to worry about. Yeah, absolutely. So now if we switch a bit, when should investors hedge and when does it actually make sense to hedge?
Rachana: Yeah. So, it's not plain and simple that you should always hedge. It really depends on the goal, time horizon, and risk appetite. So, for example if you have bond investments or you're invested for a very short period, usually hedging makes sense. Why? Bond returns tend to be small. So, any small adverse movement in currencies could actually eat into your returns quite easily.
But when you're looking at long term investments or you're looking at, you know, oh, you're okay with a bit of movement, then it matters less because in the long term, currencies tend to, you know, they move in cycles. Sometimes they're sometimes down, but they tend to balance out in the long term. So, it matters less in the long term.
The key thing here is, look, if you only want to be exposed to that asset class that you're invested in, then you should hedge. But if you're okay with a little bit of movement or you have high conviction that your local currencies or your home currency is going to weaken, you can actually boost your returns by not hedging. But you should have good conviction on that move.
Isabela: Awesome. So, shifting a bit into the actual mechanics of hedging, how do you actually hedge in practice? Like what happens behind the scenes in an ETF when it's hedged, for example?
Rachana: Yeah. Usually, ETFs use something called a forward contract. But let's again make this simple a little bit here. Assume you have a trip to Europe and six months from now, but you're worried that the Canadian dollar is going to weaken by the time the trip happens. So, you're worried that your expenses can go up when the time comes?
What can you do? Well, you can go to the bank and let's say you lock in an exchange rate. that you agree to buy a certain amount of euros. Add that exchange rate for your Canadian dollars. That means now you exactly know how many euros you'll be getting for your Canadian dollars, regardless of what happens in those six months.
So, you're locking in that exchange rate essentially as ETF, a fund manager's views forward contract to actually lock in those exchange rates. And that's because we want to make sure that your investments are reflective of the investment itself, rather than the currency swings. But it's important to note that, you know, these, these contracts could come at a cost. Forward contracts are financial agreements. and depending on the interest rate policy or gap between the two countries, you can actually be paying for this hedging. Or you could be receiving money to hedge, and the quick rule of thumb here is if you are investing in a market that has higher interest rates, let's say U.S. at this time, then you're actually paying for hedging that currency risk.
But let's say if you're investing in a market like Europe, where interest rates are lower right now, versus Canada, then you're actually receiving money, to hedge, euro, currency risk.
Isabela: So, it's like setting the price ahead of time. Awesome. So, when you see unhedged and hedged versions of the same ETF, the performance difference isn't just about the currency moves, but also it can come from the hedging cost as well. Yes.
Rachana: Yes, absolutely.
Isabela: So as a quick summary, essentially when the Canadian dollar gets stronger, your unhedged global investments can actually lose some value, even though those investments and that market might be up right now. versus vice versa as well. When the dollar weakens, it can give those same investments a bit of a boost. So, currency hedging basically what it does, it removes that noise so that your returns reflect what's actually going on in that local market.
Rachana: Yeah, that's absolutely right. And bang on.
Isabela: Perfect. So just another question for you, because I know that your team really focuses on the bigger picture currency themes. Could you maybe tell us a bit more about what are some long-term shifts that investors should keep their eye out on?
Rachana: Yeah, sure. So, when you think about what's happening right now, a lot of governments are spending money on things like infrastructure, defense spending, boosting the domestic industries. And it's partly in response to tariffs. and shifting trade dynamics. So, what's happening is these economies are trying to become more self-reliant and less dependent on, on any one region, especially the US.
So, what implications does this have on the growth side of things or for investors? It's pretty exciting because now you have many more opportunities outside of the US in your portfolio, because you could benefit from this long-term growth and income opportunities that are beyond the US. Is the opportunity right now because these economies are building, long term growth stories for themselves.
Now, on the currency side of things, as you know, the US dollar has been incredibly strong for years. which means that now, as the global growth becomes more evenly distributed, the prolonged period of U.S., dollar strength can actually come into question. We as Canadian investors have benefited for a very long time with seeing a boost to our returns.
You know, in all the US holdings that we had. But in that period, you have to be a little more cautious now with what's going on. as we just spoke about. So, as the US dollar strength starts to fade, or at least is not as strong as it has historically been. It does make sense to be mindful of your unhedged positions more so than before.
So, you know, knowing what your currency exposure is and recognizing that there are more opportunities that lie beyond the US now, I think is an important step in preparing for what's next.
Isabela: Of course. So, it's understanding that there's more out there as well and taking advantage of that and rethinking what's really going on within your portfolio.
Rachana: Yeah. So, diversifying because I think diversification has benefits now. Like there are more opportunities beyond the US. But be mindful of the currency exposure in your portfolio and be aware of it.
Isabela: Okay. So, let's wrap it up now. What should investors remember when it comes to currency hedging? Maybe I'll say one point. You say the next. Yeah, sure. Okay. So, I'm going to start off with saying that, know what you own. Check if your ETFs are hedged or unhedged.
Rachana: Okay. So, I'll say know your goals. is your goal just to be exposed to that local investment, movement or thesis that you have, then you should be hedged. So, know what? Not. Know what your goal is and be aware of the risks.
Isabela: Absolutely. And third, stay, intentional, not accidental. So, currency exposure shouldn't really just happen by default. Know whether it's helping or hurting your portfolio and make that choice consciously.
Rachana: I love that one.
Isabela: Awesome. And as always. Stay curious. Stay informed and stay invested.
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