Andrew Hallam
22.03.24

If The US Election Causes The Dollar To Crash, Should You Hedge Your ETFs To The Euro or The Pound?
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Octogenarian, Joe Biden wears the Democrat’s blue trunks. In the opposite corner is Donald Trump (with 91 felony charges against him). He’s wearing the Republican’s red.

Never before has the world had a more compelling, bizarre political fight to watch. They’ll toss punches all year.  In November, American ringsiders will decide who wins.

 You don’t need a PhD in political science to know that this is going to be ugly. Many expect (before or after the election) that the US dollar will crash.

So how do you protect yourself from this common fear?

If you’re invested in a US stock market ETF, you might be tempted to buy one hedged to the Euro or the British pound.

Before explaining whether you should, let me describe what this means. Assume you owned the iShares Core S&P 500 UCITS ETF (GSPX). It includes 500 large American stocks. The largest five holdings are Microsoft, Apple, Nvidia, Amazon and Meta Platforms (Facebook).

If this ETF were priced in USD, investors in Europe would face currency risk.  For example, if the knockout battle between Biden and Trump caused the US dollar to plunge, the S&P 500 could feasibly still rise (in USD terms) but fall badly when measured in Euros or GBP.

Such fears cause many investors to seek currency-hedged funds. For example, if the S&P 500 increased in value by 5 percent, but the US dollar fell by 20 percent compared to the British pound, then a British investor would experience a “loss.” However, if that British investor owned the iShares Core S&P 500 UCITS ETF (GSPX), which is hedged to the British pound, then the investor (if the hedging were perfect) would earn about 5 percent in GBP, despite the dollar’s drop.

Here’s another example. Imagine buying the iShares S&P 500 Euro-hedged ETF (IUSE). As with the case above, the S&P 500 could theoretically rise 5 percent in USD. The US dollar could fall 20 percent, compared to the Euro. But because of the hedging, the European investor would theoretically still make money in Euros.

It’s important to note, however, that just because an ETF is priced in a specific currency, that doesn’t mean it’s hedged to that currency. The fund’s prospectus will tell you. Look for the words “hedging” or “hedged” in the fund’s name.

Hedging or hedged. Those are popular words…especially in the run-up to the US election. Plenty of Canadian, Australian and European investors are buying or switching from regular US stock market ETFs to those that are hedged to their home currency.

Now I’ll tell you why they shouldn’t. In fact, despite their popularity, you should never buy a currency-hedged stock market ETF.

First, currency fluctuations are unpredictable.  Donald Trump could knock out Biden, strip naked during his acceptance speech and announce his conversion to Scientology. But as a result, the US dollar could rise. Currency fluctuations aren’t as predictable as you might think.

Second, currency hedging with stock market funds doesn’t work well.  Investors often believe it reduces volatility. But that isn’t true. Vanguard offers plenty of currency-hedged products. But in a 2018 Vanguard study¹, they admitted that currency-hedging (despite what we might think) doesn’t decrease volatility in a globally diversified portfolio of ETFs.  Instead, it increases volatility.

Finally, investors in currency-hedged funds make a lot less money.

For example, assume you owned a S&P 500 ETF hedged to the Euro.  Assume the S&P 500’s return in USD were 10%, 12% and 8% respectively over the next three years. If the hedging worked well, an S&P 500 ETF hedged to the Euro would earned 10%, 12% and 8% respectively, in Euros. 

But it won’t. Currency-hedged stock market funds are as backward as Biden racing next year’s Tour de France.

Before getting to that, let me give a bit of history. Canadians have been buying currency-hedged ETFs for years. They love the US stock market. But they fear what might happen if the US dollar falls.  In fact, not that long ago, the only US stock market ETFs available on the Toronto Stock Exchange were hedged to the Canadian dollar.

If the hedging worked, an iShares or Vanguard S&P 500 ETF hedged to the Canadian dollar would earn the same return in Canadian dollars as its posted return in USD. In other words, if it earned 5 percent in USD, it would earn 5 percent in Canadian dollars, regardless of how the respective currencies moved.

But for reasons I’ll soon explain, that doesn’t work.  Note the comparison below between two S&P 500 ETFs. One is priced in USD. The second is hedged to the Canadian dollar. The aim is for them to produce the same numbers in each column. But the hedged product underperformed by an average of 2.64 percent per year between 2002 and 2023.

Currency-Hedging Doesn’t Work

^{Source: portfoliovisualizer.com}

OK, so the hedging didn’t work. But in 2002, the Canadian dollar was valued much lower than it was in 2023, compared to the USD. As such, you might wonder whether someone who averaged 6.4 percent in Canadian dollars (the left column) earned more than someone who earned 9.04 percent in USD (the right column) thanks to the appreciation of the Canadian dollar (however volatile the currencies were over the time duration).

PWL Capital’s Raymond Kerzérho says no². He assessed a variety of US stock funds, hedged to Canadian dollars. He found that Canadians would have been far better off if currency hedged stock ETFs did not exist.

Here’s why it doesn’t work.

Consider an S&P 500 fund hedged to Euros.  Assume it has $100-million (U.S.) in assets under management.  At the beginning of the month, it would be long $100-million in the U.S. S&P 500.  It would also be short $100-million (U.S.) in foreign contracts versus the Euro.

If the U.S. index gained 3 percent that month, this ETF would be long $103-million.  That’s because the 3 percent rise in the U.S. market would turn $100 million into $103 million.  But because $100-million would have also been short as a currency hedge, that leaves $3-million exposed and unhedged.  If the U.S. dollar drops compared to the Euro, the $3-million in unhedged dollars would depreciate.

Most fund companies adjust their hedging monthly.  That’s why some of the assets will always be underhedged or overhedged, based on currency fluctuations.  If, for example, the S&P 500 lost money over the course of a month, then the fund would become overhedged.  Using the figures above, if the $100-million long position dropped 3 percent to $97-million, the fund would be overhedged by $3-million – exposing it to potential losses on currency movements.  That’s why currency-hedging stock market funds is a loser’s game.

Meanwhile, ignore political circuses. Build a globally diversified portfolio of ETFs.  Add money whenever you have it. An investment lifetime lasts 100 rounds. You won’t win every round. But if you don’t speculate, you will win the fight.

Sources

¹ https://www.vanguard.ca/en/404

² https://www.pwlcapital.com/currency-hedging-of-sp500-funds-a-deeper-div…

Andrew Hallam is a Digital Nomad. He’s the bestselling author Balance: How to Invest and Spend for Happiness, Health and Wealth. He also wrote Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas

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