By Ambrose O’Callaghan
You may have made up your mind to purchase an exchange-traded fund (ETF). However, you have read that there are different strategies that ETF managers employ. One such strategy is currency hedging. Should you look to purchase an ETF that uses currency hedging, or one that does not? Let’s dive in.
What is a currency hedged ETF?
Canadian investors may be attracted to the potential of foreign securities, particularly the large and diversified U.S. market held by some ETFs. However, this opens these ETFs to the potential volatility of U.S. and foreign currencies relative to the Canadian dollar (CAD). To eliminate the risk of currency fluctuations in an ETF, it may pursue currency hedging as a strategy. Why would an ETF provider employ hedging currency as a strategy?
A Canadian currency hedged ETF pursues currency hedging to protect against currency fluctuations. Ideally, this reduces the risk of fluctuations in the Canadian dollar that could negatively impact the ETF’s performance.
This is not to be confused with a Canadian currency ETF. The purpose of those ETFs is to track the performance of the Canadian dollar itself. There are other currency ETFs available in Canada that could track the performance of the U.S. dollar or the Euro, but that is a topic for another day.
The pros and cons of currency hedged ETFs
A currency-hedged ETF allows an investor to track the base performance of the index, sector, or asset class that they have purchased without having to worry about currency fluctuations. For example, you could purchase a Canadian dollar hedged ETF that is focused on U.S. equities. That ETF will rise, and fall, based on the performance of the equity and/or bond holdings therein. Meanwhile, you will not need to concern yourself with the currency fluctuations of the Canadian dollar.
What risks are associated with a currency hedged ETF?
Of course, a hedged ETF also means that you will not be able to take advantage of potentially positive fluctuations in the value of your given currency. If the Canadian dollar declines relative to the value of the U.S. dollar, you will not benefit. Thus, this is a risk-reward question that investors must determine based on their own preferences and long-term investment goals.
How does a currency hedged ETF work?
So, let’s say that we have determined we want to snatch up a currency-hedged ETF. How does this ETF work? What does CAD-hedged mean?
A currency hedged ETF and an unhedged ETF will typically use the identical asset allocation if they are issued by the same provider and track the same index or asset class. However, a currency hedged ETF will hold currency-forward contracts that perform the vital hedging function, which is to protect the portfolio from currency fluctuations.
The value of those forward exchange contracts corresponds to the value of the ETF’s assets. So, if the Canadian dollar strengthens, and thus reduces the value of your foreign investments, the forward contracts act to gain enough to offset those losses. Meanwhile, if the Canadian dollar weakens, the forward contracts will lose and subtract from any currency gain.
What types of investors would prefer currency hedged ETFs?
A currency hedged ETF offers reduced risk compared to the added possibility of currency value volatility that comes with an unhedged ETF. So, investors who don’t want to be worried about the currency risk associated exposure to those attractive foreign investments via an ETF may be more inclined to target a hedged ETF. That ETF hedge could protect an investor who doesn’t want to be exposed to an additional risk associated with investing.
Almost all Harvest ETFs utilize currency hedging. However, Harvest does believe in offering variety to investors, which is why it does offer unhedged units as part of its product mix.
