It's time to have an adult conversation about unprotected investing.
That's where you invest in U.S. and international markets without the protection of currency hedging. Hedged exchange-traded funds and mutual funds use derivatives to block out the static caused by currency fluctuations, which means you get the return of the stocks or bonds in the portfolio, minus fees.
We all know that currency volatility can have a big impact on returns in the short term. But a lot of investing pros suggest you go au naturel when making long-term investments outside Canada, which is to say without hedging.
Let's see how that's worked out using long-term stock market data to June 30.
The no-hedging approach is based on the idea that, over the long term, currency fluctuations have minimal impact on returns. It turns out that this is true a lot of the time, but not always.
The S&P 500 made an average annual 8.1 per cent in Canadian dollars for the decade to June 30 and 7.9 per cent in U.S. dollars. Over the previous 20 years, the S&P in U.S. dollars outperformed by 0.5 of a percentage point; over 30 years, the index in U.S dollars outperformed by 0.3 of a point.
Internationally, the MSCI EAFE index was almost even in terms of Canadian dollar and local currency returns over the past 10 years. The index in local currency outperformed by a substantial 1.3 points over the past 20 years, while the index in Canadian dollars was an average annual 1.8 points better over the past 30 years.
Two themes emerge from these numbers, the first being that currency fluctuations can still make a difference to your returns over the long term. The second theme is that it's impossible to know whether a hedged or unhedged product will outperform over time.
Hedged, you're protected at times when our dollar rises and erodes returns in other currencies, but you lose out when our dollar is falling and thereby enhancing returns in other currencies. Going unhedged is just the opposite – you win when our dollar's weak and lose when it's strong.
Today, with a weak dollar, unhedged investors are doing best. About seven or eight years ago, when our dollar was soaring, hedged investors made out best.
So what's the best approach to hedging over a decade or more – protection or no protection?
The answer is a half-and-half compromise – 50 per cent of your U.S. and international holdings in hedged funds and the rest in unhedged funds.
Whatever happens with our dollar over the short and long term, you're 50-per-cent protected at all times.
Rob Carrick