For Canadian investors holding foreign stocks or bonds, currency exposure can be both a source of diversification and a source of risk. Exchange rate (FX) fluctuations between the Canadian dollar and foreign currencies can impact portfolio returns — sometimes positively, sometimes negatively. Understanding how currency hedging works, and when it makes sense, is an important investment concept.
What Is Currency Hedging?
Currency hedging is a strategy that aims to reduce the impact of exchange rate movements on your foreign investments. It works by using financial instruments to “lock in” the value of foreign assets in Canadian dollars. This can help to stabilize returns and reduce volatility.
When Currency Hedging Helps
Hedging can be particularly useful in the following scenarios:
- When the Canadian dollar is expected to strengthen: A stronger loonie means foreign investments are worth less when converted back to Canadian dollars. Hedging helps protect against this decline.
- When you want to focus on investment performance: Hedging helps to remove the noise of currency movements, allowing you to better evaluate the true performance of the underlying asset. This is especially relevant for asset classes whose typical expected returns are not significantly higher than the typical volatility level (or “noise”) in FX rates – such as bonds.
- When you prefer more predictable returns: Currency fluctuations can add volatility. Hedging helps smooth out these ups and downs, which can be especially important for conservative investors or those nearing retirement.
When Currency Hedging Hurts
While hedging can reduce risk, it can also limit upside potential and add costs:
- When the Canadian dollar weakens: If you hedge and the loonie falls, you may miss out on gains from converting stronger foreign currencies back to Canadian dollars.
- Hedging costs: The cost of hedging may impact overall returns but higher yields outside Canada may make it worthwhile over time.
Striking the Right Balance
Currency exposure is an unavoidable part of investing outside Canada. Many Canadian investors choose a blended approach — hedging fixed income holdings for stability while leaving equity positions unhedged to capture potential upside.