Currency fluctuation hedged foreign content funds

[thekid]

I just wanted to know the board's thoughts on using currency fluctuation protected (aka currency hedged or currency neutral) foreign content mutual funds.

I'm fairly new to investing, so I would appreciate the input of more seasonned vets.

From my understanding, the utility for currency fluctuation hedging is debated as "most studies" seem to show that over long periods currency fluctuations cancel themselves out and hence the higher MER (typically an additional 0.15% to 0.25%) for the currency hedge is not necessary.

Do you pay for the hedge or "roll the dice" with the currency fluctuations?

This is particularly of interest to me as I am a canadian wanting significant exposure to S&P 500 indexed funds. Since 2001, the canadian dollar has gained significantly on the US dollar. Therefore, canadians holding S&P 500 indexed funds in canadian dollar accounts have seen virtually ALL of the gains of the index over the last few years disapear due to the appreaciation of the canadian dollar. By luck (I didn't know the implication of what I was doing) I had bought currency neutral index funds and caught the upswing. Seeing that the canadian dollar is close to a 30 year high, I was considering switching to a non-hedged canadian dollar account and catching the upswing should the canadian dollar revert to more historically "correct" deviations from the US dollar (it is currently at 0.90$ / five years ago it was at 0.65$).

The candian dollar implications may not be relevant for Americans on this board, but the use or not of currency hedged funds for the European / Asian / Emerging markets funds that you may hold is.

Do you pay the higher MER for currency fluctuation protection or do you "roll the dice" (may benefit, may lose from the fluctuations in the short term / may be a non issue long term).

What are you thoughts and approaches?

Thx.

[sweeps]

If I were a Canadian investing in U.S. assets I would strongly consider hedging my investment.

Note that you don't necessarily have to buy currency-neutral funds if you feel you're paying too much for the insurance. You could invest in non-hedged investments, and take out a small portion (5% maybe?) for direct currency hedges (options, futures, etc.)

Most Americans would not hedge their foreign investments because (a) the consensus is that the U.S. dollar is likely to continue its downtrend and (b) foreign investments typically make up a small percentage of Americans' portfolios. Investing in unhedged foreign funds provides some much-needed currency diversification.

[thekid]

If I were a Canadian investing in U.S. assets I would strongly consider hedging my investment.

Note that you don't necessarily have to buy currency-neutral funds if you feel you're paying too much for the insurance. You could invest in non-hedged investments, and take out a small portion (5% maybe?) for direct currency hedges (options, futures, etc.)

Most Americans would not hedge their foreign investments because (a) the consensus is that the U.S. dollar is likely to continue its downtrend and (b) foreign investments typically make up a small percentage of Americans' portfolios. Investing in unhedged foreign funds provides some much-needed currency diversification.

Thanks for the reply Sweeps. Is the US dollar really likely to stay at its current or lower level over the long term?

An alternative to the hedge, would be to purchase directly using US dollars (but then would get hit if it did go back up).

My instinct was always to hedge (which is what I have done), but the financial observers up here keep making noise that it is not necessary (as long term the fluctuations seem to even out) and that it may prevent investors (who lost on the bull of the last few years by not holding currency neutral or US dollar funds) from benefiting on the upswing should the US dollar gain from its loses.

[sweeps]

Is the US dollar really likely to stay at its current or lower level over the long term?

Ahh. If only I knew. I think one can make a strong argument that the next 10-20 years will be tough for the USD due to ballooning government spending (Iraq, social security, anti-terrorism spending, etc.) and crushing debt. But no one knows. It's true over the very long term currency fluctuations don't mean anything, but how long is the very long term? And how long will you be in this particular investment?

An alternative to the hedge, would be to purchase directly using US dollars

Sure you could do that, but then you're not really hedging. You would still be exposed to currency risk when it was time to cash out and change back to Canadian dollars.

My instinct was always to hedge (which is what I have done), but the financial observers up here keep making noise that it is not necessary

A few other considerations you may want to think about is how much of your portfolio are you investing? Are we talking 10% or 90%? If 10%, then hedging probably isn't worth it. Also you should be thinking about the future of the Canadian dollar too -- Sorry I won't be much help there.

[thekid]

Ahh. If only I knew. I think one can make a strong argument that the next 10-20 years will be tough for the USD due to ballooning government spending (Iraq, social security, anti-terrorism spending, etc.) and crushing debt. But no one knows. It's true over the very long term currency fluctuations don't mean anything, but how long is the very long term? And how long will you be in this particular investment?.

My S&P 500 indexed funds are held in my tax deferred accounts. I'm 29, so they should be there for at least another 20-25 years.

Sure you could do that, but then you're not really hedging. You would still be exposed to currency risk when it was time to cash out and change back to Canadian dollars. .

Exactly. A purchase in Canadian funds in a bet that the Canadian dollar will go up further as compared to the US dollar. A purchase in US funds is the opposite bet.

My thought was that since my holdings are in a currency hedged fund, I wasn't negatively affected by the Canadian dollar's approx 30% gain on the US dollar of the last few years. What I thought is that, given my long investment time frame, should I switch now to unhedged funds I would catch an additional upswing should the Canadian dollar return to more historically accurate rates compared to the US dollar. I would be placing a "blind" bet. I should probably just stick to the hedged funds.

A few other considerations you may want to think about is how much of your portfolio are you investing? Are we talking 10% or 90%? If 10%, then hedging probably isn't worth it. Also you should be thinking about the future of the Canadian dollar too -- Sorry I won't be much help there.

I am rebalancing my portfolio. Over the last few years the Canadian market (I refer to the S&P/TSX Composite) has significantly outperformed the S&P 500. The Canadian market is however very heavy balanced towards financial institutions (about 30% of the index) and energy/ressources (another 30%). My S&P 500 holdings made up about 20% of my total holdings. As my portfolio is growing and I'm getting more savy (at least trying to be), I'm looking to diversify as I'm way too over exposed to Canadian markets. Post rebalancing, I would like my US investments to be approx 40% of my portfolio.

[humandraydel]

Here is my amateur opinion:

The bulk of your portfolio should be neutral to currency fluctuations. For U.S. investors investing in the U.S. market, this is obviously the case. The smaller portion of your portfolio that is invested in "international" assets can (should?) be exposed to currency fluctuations. This provides a sort of inverse correlation. When the U.S. economy is not doing well and/or the dollar is falling, the international assets will provide a greater return. Similarly, when the U.S. economy is doing great and/or the dollar is rising, international assets will not provide as great of a return. The result in both of these cases is that they help to average each other out.

So, in your situation I think I would keep most of my U.S. equity exposure hedged. A smaller portion that isn't hedged would not be a terrible idea to complement the "international" part of your portfolio.

Again, just an amateur investor's opinion.

EDIT: I just noticed you said you'd like 40% to be in the U.S. market. I'd probably break down the equity portion something like this:

35-40% Canadian market
30% hedged U.S. market
10% un-hedged U.S. market
15-20% EAFE index (europe, australia, japan)
5% emerging markets

In doing this 65% of your equity assets would not be exposed to currency risk. 35% would be. Personally I dont think I'd want any more than 35% to be exposed to currency risk.

[thekid]

Thanks for the great replies and advise guys. I appreciate it!