Why Currency Exposure Should Be A Major Consideration in Your Portfolio
I have suggested for many years that currency exposure when investing globally should be a major consideration. We can only do something about it when using ETFs. Mutual funds or single stock or bonds do not give us the opportunity to hedge our exposure. To illustrate the important of currency exposure, I went back to when the world came off the gold standard in 1971 and created a table that shows the average annual change in currency, the average absolute value of the change, and the absolute value median. What we learn from this is that currency matters a lot. In fact, it’s the single largest consideration when looking at factors that impact your returns in your portfolio.
Canadian Exchange Rates: 1972-2017
Other major factors are sector exposure and security selection. You can be in the wrong sectors and securities and still make money in a bull market, but if the currency is going the opposite direction, it can and has often erased all the gains. This is especially important when looking at international developed markets outside North America where the impact is about double when compared to the Canada-U.S. dollar relationship.
Assuming you have a diversified portfolio (at least 30-50 different stocks\bonds), currency is your biggest consideration. Our chart highlights two diversified US market ETFs. Both ETFs track the S&P 500 index. ZSP has exposure to the US$ while ZUE hedges the exposure each month. It does this by looking at the value of the fund at the beginning of the month and “locks-in” the FX rate for the month with a forward contact. There is a cost for forward hedging and there are two components. The traditional bid-ask spread of the FX market maker. Typically spot plus 2-3 pips (a pip is the term used for ticks 0.0001). The second component of forward markets are interest rate differentials. That is the spread between funding costs. In the US-CAD exchange rate it’s the difference between short-term funding rates known as the overnight interest rate swap (OIS).
Currently, there is about -81 bps spread. That would be the approximate cost per year to hedge the currency. When Canadian rates are higher than US rates, the cost to hedge is actually a net positive. The lower yielding currency has to pay the interest rate differential. These costs do no show up in the MER. They are part of the tracking error factor i.e. the amount an ETF does not track the underlying cash index. Often this can be multiples of the MER, so it’s important to understand.
For me, I consider all the elements that could impact the FX rate and create what I call a fair value range. The major considerations for Canada-USD rate are interest rate differentials (this applies for all currency pairs), and often the value of some of the major trading commodities. For Canada, that is the price of crude oil. You have probably heard the C$ called a petro-currency in the past. Other issues like the NAFTA outcome and geopolitics. Consider the recent US tax cuts making Canada a bit less attractive to do business from a tax perspective.
For now, I see a 75 (1.3333) to 80 (1.2500) cent range with a move outside the range seen as temporary. I want to own exposure to the US dollar (ZSP) near 80 cents and want to be hedged (ZUE) near 75 cents. It does create more trading in your portfolio so you should consider the tax implication in taxable accounts, but often it can add 1-2% to returns annually if you are good at it.
We are in the final week of our current seminar series. Come out to one of the remaining events and learn about what ETFs can help your portfolio with the uncertain economic backdrop over the next few years. If you cannot make it, we have added a webinar on May 9 at 2 p.m. ET for those that could not attend one of our live events. Register free by clicking here. We ask BNN Viewers to make a voluntary charity donation to support Alzheimer’s research at Baycrest Hospital or Cancer research at the Hospital for Sick Children.