The impact of currency on investment returns
When purchasing foreign securities, either directly or through a fund, an
investor is subject to two sources of return: the return on the asset
itself and the return on the base currency of the asset. In a given period,
this complicates performance because currencies can either boost or detract
from returns (see the chart below). In the past two years, the Canadian
dollar’s rise against the many other currencies partially muted strong
global equity returns. In contrast, the Canadian dollar’s decline in 2015
amplified otherwise tepid global equity returns. We see that currency’s
impact on performance has varied significantly in both magnitude and
There are ways individual investors can hedge currency risk to reduce
exposure to swings in foreign exchange rates, such as through a
currency-hedged exchange traded fund. Hedging would be a plus when the
Canadian dollar strengthens, because a depreciation in foreign currencies
reduces the value of those foreign holdings. But trying to time currency
moves is difficult, to say the least. The drivers that matter most for a
given currency – from interest rate differentials and monetary policy to
investment flows and investor sentiment – can change quickly.
Toggling currency exposure to improve performance is tricky. In practice,
many investment professionals therefore don’t manage currency decisions
this way. Under the assumption that hedged and unhedged returns converge in
the very long run, which has tended to hold true, we believe volatility
reduction should be the focus for the long-term investor.
Currency hedging for the Canadian investor
A portfolio’s reference currency is the starting point for understanding
how foreign currency exposure affects volatility. We can broadly classify a
currency as either pro-cyclical or counter-cyclical, based on its
relationship with changes in global growth and financial market conditions.
When an investor’s home currency is pro-cyclical, the investor may actually
benefit from being unhedged. How? During market selloffs, a weaker domestic
currency somewhat offsets the weakness in foreign asset holdings. This is
often true for Canadian investors (see chart below). For example, in
October 2008 the MSCI All Country World Index fell 17% in local currency
terms, but in Canadian dollars the decline was only half as bad at -8%.
The chart above shows the relationship between foreign currency returns and
global equity returns, from the perspective of a Canadian dollar-based
investor. The negative correlation tells us the two returns tend to move
opposite to one another. When combined, the offsetting effect can compress
the range of investment outcomes, which lowers total volatility.
When comparing the unhedged and hedged returns across major developed
economies, we find hedging to be uniformly more volatile for Canadian
investors. This is despite currency contributing to risk in unhedged
equities. We also notice that currency exposure contributes to only a
modest portion of unhedged equity risk, suggesting it shouldn’t be a
principal concern when investing globally.
What about emerging market equities? The same preference of remaining
unhedged applies, but for different reasons. The interest rate differential
between emerging and developed markets, which helps bolster emerging market
currencies, could provide a source of total return to Canadian investors.
Second, hedging emerging market currencies can be impractical or
prohibitively expensive, creating a drag on returns.
We believe it makes sense for Canadian dollar-based investors to retain
currency exposure in non-domestic developed market and emerging market
Director, is BlackRock’s Chief Investment Strategist for Canada and is
a member of the BlackRock Investment Institute (BII).
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