Monday, February 15, 2010

The Currency Hedging Myth

They say the definition of insanity is when you do the same thing over and over expecting a different result. Do you ever wonder why the financial media keeps asking industry experts to recommend a “solid diversified” equity portfolio using exchange traded funds (ETFs) and expecting some kind of new concept or breakthrough analysis?

The recommendations are usually to own some Canada along with mix of “currency hedged” global exposure such as U.S., Europe, Asia Pacific, Emerging Markets & Japan ETFs and maybe some speciality theme like AGRA or Green Energy. The idea is to own a basket of assets that have some degree of non-correlation but the problem is – thanks to Globalization – all of the global bourses have a high degree of correlation. In other words all of the global markets rise and fall at the same time admittedly with some difference in magnitude.

Today the only way we can achieve any degree of diversification is by global currency exposure. That means we should avoid currency hedged investment products. You see if we diversify by country or region and wrap it all in currency hedges – we may as well just own one security – our own S&P/TSX60 Index. One example of an “avoid” product would be the iShares CDN S&P 500 (XSP) Hedged to Canadian Dollars Index Fund seeks to provide long-term capital growth by replicating, to the extent possible, the performance of the S&P 500 Hedged to Canadian Dollars Index. This product was introduced in May 2001 and adopted the dollar hedge in November 2005 in reaction to the 2003-2005 run up in the Canadian dollar. Remember in order to increase market share the manufacturers of ETF products have to create sexy add-ons such as currency hedging and managed products in order to “excite” retail investors.

Back to investing reality - our CDN dollar model displays two material hedging problems. The CDN dollar hedge is a wash since mid 2007 (it actually backfired in 2008) and our CDN $ model is about to generate a “sell” signal. Also something to keep in mind if your over-weight in commodities

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