For Canadian investors who hold foreign assets, currency fluctuations can significantly impact returns. When the loonie weakens, each U.S. dollar of gains converts into more Canadian dollars; when it strengthens, the opposite happens.
Currency hedging helps manage this risk by reducing the impact of exchange rate movements, ensuring that investment returns reflect the performance of the underlying assets rather than currency volatility.
Learn more about currency-hedged ETFs from Paul Pincente, our VP of Digital Assets, in the video below.
How Does Currency Hedging Work?
Currency hedging is a risk management strategy used to protect investments from fluctuations in foreign exchange rates. When Canadian investors purchase foreign assets, they are exposed to two main risks: the performance of the asset itself and changes in the value of the Canadian dollar relative to the foreign currency.
For example, if you invest in a U.S. stock and the stock price rises, your return in Canadian dollars depends not only on the stock's appreciation, but also on the CAD-USD exchange rate. If the Canadian dollar gains on the U.S. dollar, your gains may be reduced or even erased. Conversely, if the Canadian dollar drops, your returns could be amplified. Currency hedging helps offset the impact of exchange rate movements.
ETFs that invest in foreign securities often offer currency-hedged versions to mitigate currency risk. These ETFs use financial instruments, primarily currency forwards, to offset the effect of currency fluctuations.
A currency forward is an agreement to exchange one currency for another at a predetermined rate on a future date. If a Canadian ETF holds U.S. stocks, the fund manager might sell U.S. dollars forward and buy Canadian dollars in the futures market to hedge against a rising Canadian dollar. This way, investors' returns are driven solely by the performance of the underlying stocks, rather than by currency movements.
What Costs Are Associated with Currency Hedging?
Hedging comes with costs that investors should consider before choosing a hedged ETF. These costs can be broken down into two main categories:
- Interest Rate Differential – The return on currency forward contracts is influenced by the interest rate difference between the two currencies involved. If Canadian interest rates are higher than U.S. rates, hedging can generate a small benefit. If they are lower, it can add a cost. For example, if Canada's short-term interest rates are 1% higher than those in the U.S., a Canadian investor would gain approximately 1% from hedging over a year.
- Execution & Admin Costs – Rolling the forwards each month typically costs 5–13 bp of assets annually for large, liquid pairs such as USD/CAD.
While these costs are relatively small, they can add up over time and should be weighed against the potential benefits of hedging.
Why Is Currency Hedging Relevant for Canadian Investors?
Currency hedging is especially relevant for Canadian investors in times of economic uncertainty and shifting trade policies. The Canadian dollar is highly sensitive to global commodity prices and trade relations. Because crude exports supply a large share of Canada’s FX earnings, oil-price swings often drive CAD direction. Trade and tariff frictions can also hurt export confidence, weakening the loonie and impacting investment returns.
For example, if Canada faces increased tariffs on exports to the U.S., the Canadian dollar may weaken due to reduced trade confidence. In this scenario, unhedged investments in U.S. assets would benefit, as the exchange rate would increase the value of U.S. dollar-denominated investments when converted back to Canadian dollars. However, if trade tensions ease and the Canadian dollar strengthens, hedged ETFs would provide more stable returns compared to unhedged alternatives.
Ultimately, whether to hedge currency risk depends on an investor's outlook on the Canadian dollar, their risk tolerance, and their investment objectives. While hedging can provide stability and predictability, it also limits the potential upside from favourable currency movements. Canadian investors should carefully assess the role of currency hedging within their portfolios, especially in the context of ongoing economic and geopolitical uncertainty.
Final Thoughts
Currency hedging in ETFs offers a way for Canadian investors to manage exchange rate risks when investing in foreign assets. While it can help stabilize returns, it comes with costs. It can dampen FX noise, but also forfeits any upside from a falling loonie.
Before investing, decide whether you have a view on CAD and whether you need the smoother ride that hedging provides; then weigh the ~5–15 bp annual drag against that peace of mind. Understanding these trade-offs can help Canadian investors make informed decisions about adding currency-hedged ETFs to their portfolios.
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