I’m getting a lot of questions about asset allocation and the percentage of your equities (stocks) you should allocate to your home country. This is a much bigger question for those of us who live outside of the world’s largest economy but still want to be heavily invested in it. With that in mind, I’m posting an excerpt on currency risk from my book. This is a controversial topic so I’m open to feedback and the exchange of ideas. Find me on Twitter or Reddit or comment below!
Is Currency Risk a Part of a Diversified Portfolio?
Some aspects of personal finance have absolute, right and wrong, answers. This is not one of them. Currency risk and hedging are complicated topics and seem particularly prone to conflicting opinions, poorly done academic research, and bias. There is also not a once size fits all approach applicable here because, as we discussed before, there are many ways to achieve a diversified portfolio.
Before we start, let’s familiarize ourselves with a couple of definitions.
Currency risk: This is the risk of potential loss from fluctuating currency exchange rates. If a Canadian investor holds American stocks and the Canadian dollar increases in value relative to the American dollar (i.e. the American dollars goes down in value relatively), the investor’s stock loses value when presented in Canadian dollars.
Currency hedging: Hedging is a tactic used to limit the potential losses of an investment. An exchange traded fund (ETF) can hedge for currency risk by using contracts that lock in the price they will pay in the future for different currencies.
For Americans, there is no reason to stray too far from a cap-weighted approach that holds each stock relative to its market value. Because American stocks make up 55% of the world’s market cap, an investor following a cap-weighted approach would hold about that amount. For investors who live in countries with relatively small stock markets (e.g. Canada has less than 4% of the world market cap), this is an impractical option. There are a myriad of reasons (as we’ve discussed in Asset allocation: Picking the right portfolio) that Canadians shouldn’t have 96% of their equities exposed to currency risk. The simplest solution for Canadians is to hold more Canadian stocks, perhaps even up to 30%. Another option for Canadians is to use something closer to a market-cap weighted approach with the help of currency hedging to reduce currency risk.
The first thing to determine is whether your home country currency is pro-cyclical. A pro-cyclical currency is one that has historically strengthened relative to other currencies when stocks have done well. The Canadian dollar (CAD) and Australian dollar (AUD) have historically been pro-cyclical, as demonstrated in 2015 when the world stock markets suffered and both currencies lost relative value. The Japanese Yen and American Dollar (USD), on the other hand, have historically been counter-cyclical as people were driven to these currencies (thus bidding their prices up) in bad economic times.
As noted by Sanne de Boer et al., there is a natural hedging affect achieved by all pro-cyclical currencies. When the world’s stocks go up, the Canadian investors’ gains are restrained by a strong CAD. For example, picture someone exchanging $100 CAD for $100 USD and then spending it all on American stock. That person would be elated when their investment doubled to $200 USD but it’s likely that the CAD increased in value at the same time. In Canadian dollars, the value of their investment might only be $150 or $170. The opposite is also likely to happen when American stocks go down: here, the loss would be tempered by a relatively strong American dollar (and weak CAD).
As demonstrated above, there’s an argument to be made that Canadian or Australian investors (being from countries with pro-cyclical currencies) don’t need to use currency hedged ETFs or other products. In fact, hedging might make their portfolios more volatile and risky, instead of less so. It’s hard to say with real certainty. All of this gives rise to more questions than answers for Canadian investors. Will the CAD continue to be pro-cyclical in the future and can the average investor rely on its natural hedging affect? Will the Canadian economy continue to rely on its natural resource sector? Will the TSX continue to mirror American stock markets, albeit with more volatility? These types of macroeconomic questions are interesting to think about but are ultimately futile. No one really knows the answers.
Others still maintain that a market-cap weighted approach using non-currency hedged products is a viable option for Canadians. This is based on the idea is that although 96% of the equities in their portfolio would be subject to currency risk, a lot of the currencies in that 96% act against each other; so, in the end, it will all just even out anyway. This is sound logic for Americans using a market-cap weighted approach because the 45% of their equities that are exposed to currency risk are made up of many relatively small currencies. But for Canadians, 55% of the other 96% of the stock market is American stocks, and trades in USD. What if the relationship between American and Canada fundamentally changes? The currency risk in your portfolio wouldn’t “balance itself out”, so to speak, in this case.
Unlike the historical evidence that stocks trend upwards overtime, there’s no law or evidence that says currencies must return to their historical averages. Try telling that to Japanese investors from the late 1980s. And even if currencies return to their historical averages, they may not do so on your timetable. It would not be fun to be of retirement age but unable to retire because you’re waiting for years of currency swings to correct itself to your advantage.
We can conclude that investors from countries with boutique stock markets, like Canada and Australia, have to do something to reduce their currency risk. The two prevalent options are a home country bias, as we discussed previously, and using currency hedged ETFs with a market cap weighted approach.
Using currency hedged ETFs to reduce your currency risk has its own drawbacks. For one, the fees are slightly higher, typically 0.1% more than their unhedged counterparts, and we all know what the smallest of fees can do to your portfolio in the long-run. These products have also been known to have tracking errors in the past. This means that they have more difficulty than unhedged products in accurately representing their underlying index or benchmark. This seemed to be more of an issue about five years ago when these products first came on the market. Investment firms seem to have resolved it for now.
For those who don’t want to use a home country bias strategy because of the lack of industry diversification found in small markets like Canada, a currency hedged market-cap weighted approach would be one way to diversify your portfolio. One of the most popular ways to do this is a 50/50 hedged/unhedged split, also dubbed “the allocation of least regret.” The equity portion of this portfolio might look like this:
|Equity Portion of “The Allocation of Least Regret” Portfolio||Allocation|
|Canadian All-Cap ETF||10%|
|American All-Cap ETF||25%|
|American All-Cap CAD-Hedged ETF||25%|
|Ex -North-America All-Cap ETF (All stocks outside of NA)||20%|
|Ex-North America All-Cap CAD-Hedged ETF (All stocks outside of NA)||20%|
Whether you want to have a home country bias or use currency hedged products is up to you. The choice is yours but keep in mind that the choice doesn’t matter if you change your approach often. It is most important to stay dedicated to the stated goals of your portfolio and the allocation therein. Pick an allocation and stick to it, re-balancing once or twice a year. Making adjustments to your target allocations because of a change in currency value is a gamble and if you aren’t knowledgeable enough to gamble with individual stocks, you’re definitely not smart enough to gamble with currencies.