ELI5 - Currency Hedging

Safety in investing is often associated with lower returns, no risk, no reward. However, diversification presents an exception to this rule. It's been shown that spreading your investments across the globe reduces risk while simultaneously increases your expected returns.

"Diversification is the only free lunch in finance" 
       - Harry Markowitz, Nobel prize winning economist

Global diversification is indeed beneficial, but it's important to recognize the added factor it brings to your portfolio. When you own international stocks, you gain exposure to foreign companies AND their currencies, thus you'll need to deal with fluctuations in stock prices and exchange rates.

Let's demonstrate this with an example.

Carl Buys American 

Carl is a Canadian investor who wants exposure to the US market. To do this, he buys SPY, an ETF that tracks the S&P 500. Carl is now the proud (part) owner of the largest 500 companies in America.

Over the year, US stocks skyrocket and SPY experiences a 20% gain.

Pretty sweet, right? Don't count your chickens just yet, Carl. There's more to the story.

As a Canadian investor, your actual return is determined by how the US dollar performs relative to the Loonie.

Scenario 1 - The US Dollar Sinks

If the US dollar drops, Carl's return would also drop. A weaker US dollar dampens the returns from US stocks. A 5% drop in the US dollar would've reduced Carl's gain to 15%, a 20% drop would've wiped it out completely.

Scenario 2 -  The US Dollar Soars

If the US dollar rises, Carl's return would've been magnified. A 20% rise in the US dollar would've ballooned Carl's return to 40%.

Currency Hedging

Some funds attempt to remove the currency risk through a strategy known as currency-hedging.

To hedge, funds use currency forwards. These are contracts that enable you to lock in an exchange rate.

Take for example, a Canadian-hedged ETF that tracks the S&P 500. The ETF would buy currency forwards to lock in the US exchange rate for a specific period.

• If the US dollar declines, the forward's value would rise since the contract locked in a higher (more favourable) exchange rate. The gain by the forward contract would offset the loss caused by the US dollar decline.

• If the US dollar rises, the forward's value drops since the contact locked in a lower (less favourable) exchange rate. The loss by the forward contract would offset the gain caused by the US dollar rise.

Hedging looks to remove the impact of currency fluctuations, whether good or bad. 

Should I Use Currency-Hedged Products?

Hedged products are more expensive and more complicated than their unhedged counterparts. The additional complexity results in greater tracking error - the difference between a fund's returns and the index it's trying to replicate. 

There's no evidence that hedged products outperform. Exchange rates are unpredictable. Sometimes you win, sometimes you lose. Over the long term, the fluctuations have been shown to even out and become largely a non-factor. 

Since there's no notable performance benefit, I'll defer to Occam's Razor, going with the simpler option. Saving me the hassle and the fees.