Special Feature

ETF Guide 2015

This web-exclusive companion to Investment Executive's ETF Guide for Financial Advisors, 2015, offers insight on helping your clients understand their choices among exchange-traded funds (ETFs). In a video, Hugh Murphy, managing director of Credo Consulting, discusses the results of a recent survey of how advisors are using ETFs. Stay tuned for more web-exclusive content.

ETFs provide many options for hedging, but you need to ask whether or not this is necessary for your clients

By Dan Hallett | May 2015

Big currency moves tend to place foreign currency exposure atop the minds of financial advisors and their clients alike. In 2002, with the Canadian dollar (C$) dropping like a stone, there were warnings of further declines and the merits of adopting a North American dollar were considered. Just a few years later, during the C$'s commodities-driven march toward parity with the U.S. dollar (US$), hedging foreign currency exposure was popular. Big currency moves over the past year may again be influencing investment decisions.

The exchange-traded fund (ETF) industry was early out of the gate with currency-hedged products. Today, there are more than 60 ETFs offering exposure to non-Canadian stocks and bonds without the non-Canadian currency exposure. Ease of access may tempt clients to include C$-hedged ETFs in their portfolios if those clients are rattled by big currency moves.

However, it may be helpful to take a step back and consider the following strategies, which can be used to deal with currency effectively without the challenging task of having to forecast a currency's direction:

- Match assets with liabilities. This is the most strategic approach, and starts with understanding the purpose of a portfolio. If this purpose includes covering costs of travel to Florida, for example, then that is best addressed by carving out an amount to be set aside in safe, liquid US$ investments so the client has the amount of cash required at the time it's needed. That way, the portion of the portfolio that is meant to fund longer-term goals can be invested in an appropriate mix of longer-term investments - without a separate currency call. This circumstance calls for keeping US$-denominated assets to cover US$ spending.

The 20 US$-denominated ETFs that trade on the Toronto Stock Exchange offer many options for mid- to longer-term goals. But only two ETFs come close to being suitable for nearer-term goals. Horizons U.S. Dollar Currency ETF is a holding spot for US$ cash but pays no interest. Horizons Active U.S. Floating Rate Bond ETF involves some credit risk, but it's investment-grade and hedges duration risk. In contrast, the yield and return potential for Horizons Active U.S. Floating Rate Bond ETF are insufficient for the associated cost and risk.

A U.S.-domiciled, very short-term government bond ETF or US$ savings account may be more appropriate for this purpose.

- Diversification hedge. Well-diversified portfolios aren't as exposed to currency as many people think. For example, consider a balanced portfolio invested 60% in stocks and 40% in bonds. Let's assume that all of the bonds are Canadian (as usually is the case) and that equities are split one-third into Canadian stocks and two-thirds into global stocks.

As of Jan. 31, 2015, this hypothetical portfolio had roughly 23% direct US$ exposure (based on the respective weightings in the MSCI world index).

During the past one-, five- and 10-year periods, this portfolio's annualized returns were 15.1%, 10.5% and 7%, respectively. If we use currency-hedged global stocks rather than unhedged, there's no foreign currency exposure and the one-, five- and 10-year returns would have been 12.6%, 9.7% and 7.1% a year, respectively, as of Jan. 31.

Note that there were big performance differences in shorter time frames, but total returns over a decade were virtually identical. However, total portfolio risk was 20%-25% lower without hedging, based on downside risk and volatility measures.

Hedging can work out well at times. But the combination of time and diversification (by both asset class and currency) will minimize the importance of currency decisions in a total portfolio context.

- Any currency hedging should be driven by client-specific circumstances and in the spirit of risk management. In border cities, many Canadians have U.S. employers and are paid in US$. Similarly, many Canadians have spent significant time working in the U.S. Other clients may be receiving pensions from Europe.

Whatever the circumstances, some clients already have large currency exposures via some asset or income source. If the non-Canadian income roughly covers the cost of trips back to that other country, the long-term portfolio shouldn't need any kind of hedge to reduce exposure. However, if the source of income or asset value is very significant, it probably makes sense to hedge part of the long-term portfolio to avoid overexposing a client to a foreign currency.

ETFs offer C$-hedged exposure to everything from broad stock indices (Canadian, U.S. and EAFE) and bonds (high-yield, emerging markets) to narrow market slices and commodities. These all can be effective in managing currency risk, but I prefer exposure provided by the broader stock market indices.

In the absence of a real need to hedge, some combination of the first two strategies - executed well - will ensure that your clients have appropriate exposure.

Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for institutions and affluent families.

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