Currency: To Hedge or Not to Hedge

Feb. 28, 2023


For Canadians, foreign investing can be extremely important when it comes to portfolio construction, given the narrow sector diversification in Canada. Innovation in the ETF industry has allowed investors to easily access various assets from different regions of the world. However, when investing in non-Canadian assets, investors have two sources of return: the return of the security and the return of the foreign currency relative to the Canadian dollar (CAD). Each of these two sources can each be positive or negative. 

At times, currency can even detract from the positive returns of a security and result in a negative return when translated into CADs. In addition to the easy access to international markets, ETFs often allow investors to hedge out the risk of currency. Currency-hedged ETFs aim to mitigate the returns from currency, virtually allowing investors to participate in global markets as if they are local. As an example, investors that want to invest in the S&P 500 Composite Index, with the impact of the US dollar (USD)/CAD currency effect may want to consider the BMO S&P 500 Index ETF (ticker ZSP). Those investors that want to mitigate the impact of currency risk may want to consider the BMO S&P 500 Hedged to CAD Index ETF (ticker: ZUE). Investors should note that the currency-hedged returns are not exactly local returns, as the industry standard is for currency hedges to be implemented and rolled once a month, so intra-period moves can cause the hedged returns to be slightly different than local returns. Nevertheless, the hedged returns should be very close to local returns. 

To demonstrate the impact of currency, below are the calendar year returns of ZSP and ZUE.1


BMO S&P 500 Composite Index ETFZSP12.37%3.44%24.35%15.67%27.53%-12.63%
BMO S&P 500 Hedged to CAD Index ETFZUE21.22%-6.12%29.19%15.24%27.88%-19.41%
Difference (Currency Effect*)-8.85%9.56%-4.66%0.43%-0.35%6.78%

Source: Bloomberg, BMO Global Asset Management. Currency-hedged ETF is used as a proxy to local returns. In practice there may be differences in returns between the currency-hedged ETF and local returns, due to the shift in the hedge ratio intra-period as hedges are rolled monthly.

BMO Capital Markets USD/CAD forecast

The CAD is projected to increase by 4.39% over 2023. This trend is expected to continue in 2024 for a total appreciation of 6.23%.


Source: As of February 24, 2023.

As illustrated, the impact of currency in certain periods could be significant, making the decision of whether or not to hedge currency risk essentially as critical as which exposure you want to invest in. During some periods, the exposure to currency can be positive, while at others times it can be negative. Below we highlight our current views on the currencies of specific regions. 

US Dollar

Coming into the year, it looked as if the U.S. Federal Reserve (Fed) had a lead on its quest to tame inflation. However, recent data has suggested that inflation in the U.S. has accelerated with the U.S. Personal Consumption Expenditure Core Price Index (PCE) year-over-year moving back up. In addition, the unemployment rate in the U.S. remains low. As a result, the interest rate path of the Fed has been repricing in recent weeks, with longer-term rates and overnight index swaps suggesting rates will remain restrictively high.

The Bank of Canada (BoC), on the other hand has seen its inflation numbers continue to decelerate, which has led the BoC Governor to suggest a pause is warranted. The repricing over the short-term is bullish for the USD, but at some point, the BoC will have to consider the impact on its currency, as a weaker loonie would mean we would import inflation. This means that nothing happens in a silo, and the BoC will have to consider the Fed’s moves at some point, which means U.S. inflation data should also be critical for Canadians. From a tactical standpoint, we would consider unhedging USD exposure over the short term, while hedging USD exposure over the long term. For long-term strategic positions, we would go with unhedged as the USD adds diversification particularly during flight-to-safety scenarios. 


While the USD has been relatively rangebound compared to the CAD, viewing it relative to the Euro really shows the recent weakness of the greenback. With the Fed looking like they have a better grip on inflation relative to the Eurozone, it’s anticipated the Fed will ease on its tightening while the European Central Bank (ECB) will have to continue hiking. While this should favour the Euro over the USD, its position relative to the CAD could be different if the BoC prolongs its hiking cycle. However, with the BoC likely pausing its rate hiking, it’s likely the Euro will gain, relative to the loonie. Investors that simply want to take that risk off the table may want to seek a currency-hedged alternative. 


As mentioned, the Euro can continue to see gains relative to the CAD, should the BoC pause its rate hikes. For a broader basket of foreign currency in an international EAFE basket, there would obviously be more noise, given the larger number of currencies with international exposure. However, given that the Association of Southeast Asian Nations (ASEAN) and the Eurozone are China’s main trading partners, and the recent shift away from Zero-COVID policies, international currencies may potentially appreciate relative to the CAD. Even Japan, which has been notorious for its decades of deflationary conditions, is expected to see a series of rate hikes by the Bank of Japan (BoJ) as it looks to tame its own inflation.

As previously noted, the ETF industry provides many access tools for investors to seek exposure in non-Canadian areas of the market. The decision to hedge currency this year could be an important one, as central banks remain at various stages in their efforts to rein in inflation, which would create changes in interest rate differentials and result in potential currency volatility.

1 BMO Global Asset Management, as of February 28, 2023. ZUE Annualized Performance: 1-year: -9.74%, 3-year: 8.07%, 5-year: 7.70%, 10-year: 11.40%, Since Inception (May 29, 2009): 12.22%. ZSP Annualized Performance: 1-year: -4.23%, 3-year: 9.75%, 5-year: 10.88%, 10-year: 15.52%, Since Inception (November 14, 2012): 16.24%.


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