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Investments in overseas instruments, such as stocks and bonds, can generate substantial returns and provide a greater degree of portfolio diversification, but they introduce an added risk, that of exchange rates. Since foreign exchange rates can have a significant impact on portfolio returns, investors should consider hedging this risk where appropriate. While hedging instruments such as currency futures, forwards and options have always been available, their relative complexity has hindered widespread adoption by the average investor.

On the other hand, currency ETFs, by virtue of their simplicity, flexibility and liquidity, are ideal hedging instruments for retail investors who wish to mitigate exchange rate risk.

SEE: Hedging With ETFs: A Cost-Effective Alternative

Impact of Exchange Rates on Currency Returns

The first decade of the new millennium proved to be a very challenging one for investors. U.S. investors who chose to restrict their portfolios to large-cap U.S. stocks saw the value of their holdings decline by an average of more than one-third. Over the approximately nine-and-a-half-year period from January 2000 to May 2009, the S&P 500 index fell by about 40%. Including dividends, the total return from the S&P 500 over this period was approximately -26% or an average of -3.2% annually.

Equity markets in Canada, the largest trading partner of the U.S., fared much better during this period. Fueled by surging commodity prices and a buoyant economy, Canada's S&P/TSX Composite index rose about 23%; including dividends, the total return was 49.7%, or 4.4% annually. This means that the Canadian S&P/TSX Composite index outperformed the S&P 500 by 75.7% cumulatively or about 7.5% annually.

U.S. investors who were invested in the Canadian market over this period did much better than their stay-at-home compatriots, as the Canadian dollar's 33% appreciation versus the greenback turbocharged returns for U.S. investors. In U.S. dollar terms, the S&P/TSX Composite gained 63.2%, and provided total returns, including dividends of 98.3% or 7.5% annually. That represents an outperformance versus the S&P 500 of 124.3% cumulatively or 10.7% annually.

This means that $10,000 invested by a U.S. investor in the S&P 500 in January 2000 would have shrunk to $7,400 by May 2009, but $10,000 invested by a U.S. investor in the S&P/TSX Composite over the same period would have almost doubled, to $19,830.

When to Consider Hedging
U.S. investors who were invested in overseas markets and assets during the first decade of the 21st century reaped the benefits of a weaker U.S. dollar, which was in long-term or secular decline for much of this period. Hedging exchange risk was not advantageous in these circumstances, since these U.S. investors were holding assets in an appreciating (foreign) currency.

However, a weakening currency can drag down positive returns or exacerbate negative returns in an investment portfolio. For example, Canadian investors who were invested in the S&P 500 from January 2000 to May 2009 had returns of -44.1% in Canadian dollar terms (compared with returns for -26% for the S&P 500 in U.S. dollar terms), because they were holding assets in a depreciating currency (the U.S. dollar, in this case).

As another example, consider the performance of the S&P/TSX Composite during the second half of 2008. The index fell 38% during this period - one of the worst performances of equity markets worldwide - amid plunging commodity prices and a global sell off in all asset classes. The Canadian dollar fell almost 20% versus the U.S. dollar over this period. A U.S. investor who was invested in the Canadian market during this period would therefore have had total returns - excluding dividends for the sake of simplicity - of -58% over this six-month period.

In this case, an investor who wanted to be invested in Canadian equities while minimizing exchange risk could have done so using currency ETFs. The following section demonstrates this concept.

Hedging Using Currency ETFs

Consider a U.S. investor who invested $10,000 in the Canadian equity market through the iShares MSCI Canada Index Fund (EWC). This ETF seeks to provide investment results that correspond to the price and yield performance of the Canadian equity market, as measured by the MSCI Canada index. The ETF shares were priced at $33.16 at the end of June 2008, so an investor with $10,000 to invest would have acquired 301.5 shares (excluding brokerage fees and commissions).

If this investor wanted to hedge exchange risk, he or she would also have sold short shares of the CurrencyShares Canadian Dollar Trust (FXC). This ETF reflects the price in U.S. dollars of the Canadian dollar. In other words, if the Canadian dollar strengthens versus the U.S. dollar, the FXC shares rise, and if the Canadian dollar weakens, the FXC shares fall.

SEE: Introduction to Short Selling

Recall that if this investor had the view that the Canadian dollar would appreciate, he or she would either refrain from hedging the exchange risk, or "double up" on the Canadian dollar exposure by buying (or "going long") FXC shares. However, since our scenario assumed that the investor wished to hedge exchange risk, the appropriate course of action would have been to "short sell" the FXC units.

In this example, with the Canadian dollar trading close to parity with the U.S. dollar at the time, assume that the FXC units were sold short at $100. Therefore, to hedge the $10,000 position in the EWC units, the investor would short sell 100 FXC shares, with a view to buying them back at a cheaper price later if the FXC shares fell.

At the end of 2008, the EWC shares had fallen to $17.43, a decline of 47.4% from the purchase price. Part of this decline in the share price could be attributed to the drop in the Canadian dollar versus the U.S. dollar over this period. The investor who had a hedge in place would have offset part of this loss through a gain in the short FXC position. The FXC shares had fallen to about $82 by the end of 2008, so the gain on the short position would have amounted to $1,800.

The unhedged investor would have had a loss of $4,743 on the initial $10,000 investment in the EWC shares. The hedged investor, on the other hand, would have had an overall loss of $2,943 on the portfolio.

Currency ETFs Are Margin-Eligible

Some investors may believe that it is not worthwhile to invest a dollar in a currency ETF to hedge each dollar of an overseas investment. However, since currency ETFs are margin-eligible, this hurdle can be overcome by using margin accounts (which are brokerage accounts in which the brokerage lends the client part of the funds for an investment) for both the overseas investment and currency ETF.

An investor with a fixed amount to invest who also wishes to hedge exchange risk can make the investment with 50% margin and use the balance of 50% for a position in the currency ETF. Note that making investments on margin amounts to using leverage, and investors should ensure that they are familiar with the risks involved in using leveraged investment strategies.

SEE: Leverage's "Double-Edged Sword" Need Not Cut Deep

The Bottom Line
Currency moves are unpredictable and currency gyrations can have an adverse effect on portfolio returns. As an example, the U.S. dollar unexpectedly strengthened against most major currencies during the first quarter of 2009, amid the worst credit crisis in decades. These currency moves amplified negative returns on overseas assets for U.S. investors during this period. Hedging exchange risk is a strategy that should be considered during periods of unusual currency volatility. Because of their investor-friendly features, currency ETFs are ideal hedging instruments for retail investors to hedge exchange risk.

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