To hedge or not to hedge? That is the question when investing in the U.S. market

I think we can all agree that investing in the U.S. stock market is a valuable exercise. There are global companies in the U.S. that are great long-term stocks that we should own as well as important diversification benefits that Canadians achieve by investing away from Canada.
Canadians like to invest at home, but what we really need to understand is that Canada’s stock market is one big illiquid sector bet. Our market is dominated by three major sectors – financials, energy and commodities. On the other hand, the U.S. stock market is huge, with deep and broad representation across all the major industry sectors. That said, investing in the U.S. comes with a unique challenge that you don’t have when investing at home: currency risk.
There are two ways to approach fluctuating currency when investing in the U.S. market. The first is to adopt a thesis by which you buy into the U.S. market knowing and accepting that there will be times when the U.S. dollar strengthens or weakens versus the Canadian dollar. The second is to use a currency hedge solution. There are advantages to each approach.

To hedge
For those of us who are individual investors, hedging is generally not a good option. You need to accept the currency risk when investing in individual U.S. stocks. But in the ETF and the mutual fund industry, there are lots of funds that offer currency hedging as a part of the strategy, aiming to eliminate the fluctuations of the currency. For example, if you buy the S&P 500 Index and use a currency-hedged fund, you can just worry about the way the stock market moves rather than worrying about the direction of the U.S. dollar – essentially investing just like a local U.S. investor.

Not to hedge
There’s something to be said if you’re not currency hedging and exposing your portfolio to U.S. currency. Of course, given the strength of the U.S. dollar relative to the Canadian dollar lately, many Canadian investors have seen a significantly positive result in recent years. But regardless of short-term direction, there is a significant argument for long-term investors to choose not to hedge their currency exposure. Currency exposure in general, especially the U.S. dollar, can act as a nice ‘volatility dampener’ for Canadians buying U.S. stocks through different investment cycles. History has shown that the U.S. dollar has strengthened during times of stress.

What happens a lot of the time is a ‘flight to quality,’ whereby investors who are uncertain about what is going on, flock to the U.S. dollar and to U.S. Treasuries. When you look out over a 10+ year timeframes, then the addition of U.S. currency exposure can really help provide potentially better risk-adjusted returns on equities. So there is strong merit to not currency hedging your U.S. stock exposure.

Applying hedging to your investment strategy
At the core of all of this, and our approach to the hedging question for investment funds, is knowing the long-term goal we are trying to achieve with the strategy.
At Purpose, we implement a currency hedge in funds we manage where we invest across North American stocks (e.g., Canadian and U.S. securities). We really believe that in these cases including the U.S. stocks ensures sector diversification and access to a broader universe of companies. By hedging the U.S. dollar exposure we try and focus exclusively on the equity return opportunity from the U.S. stocks and ensure that gains from U.S. stocks are not affected by currency changes.

On the other hand, in funds where we are invested exclusively in the U.S. stock market, we offer investors a choice to either use hedged or unhedged exposure, allowing you to decide what is best for your long-term portfolio and goals. Whether you want to hedge over the next few months, or want to switch to unhedged exposure, by offering options we’re also giving investors the flexibility to switch over time depending on their views on the U.S. dollar.

Finally, if you’re investing in international equity portfolios, we recommend not currency-hedging your exposure. The big advantage to owning international stocks, in our opinion, is their exposure to a diverse set of currencies. We believe investors should take advantage of the significant diversification benefit these currencies have over time to a long-term equity investor.

The lesson at the end of all of this is that currency risk definitely needs to be taken into consideration when investing in the U.S. Whether you believe that the U.S. dollar will strengthen or weaken versus the Canadian dollar, you need to decide whether you will accept currency risk or hedge it out. There are advantages to both strategies depending on your time horizon and portfolio makeup. To hedge or not to hedge depends on your preferences as an investor.

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