Currency: To Hedge or Not to Hedge

Jan. 24, 2023


For Canadians, foreign investing can be extremely important when it comes to portfolio construction, given the narrow sector diversification is 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 local 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 Composite Hedged to C$ 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.

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

In the quest to tame inflation, the U.S. Federal Reserve (Fed) has seemingly pulled ahead of the Bank of Canada (BoC), based on the recent trend in each of their inflation data. While both central banks are largely anticipated to take a pause on their monetary tightening in early 2023, it is likely that if either has to prolong its hiking cycle, it would be the BoC. This is due to its recent, more resilient inflation data, compared to the U.S. Should this occur, the interest rate differential between the USD/CAD would widen in favour of the Canadian dollar. The USD remains closer to the higher range of where it historically trades, relative to its Canadian equivalent. Should energy remain in strong demand, it would also be further reason for investors to currency hedge their USD exposure.


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, should the BoC pause its tightening cycle, it’s likely the Euro will also 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. 

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 December 31, 2022. ZUE Annualized Performance: 1-year: -19.41%, 3-year: 5.92%, 5-year: 7.57%, 10-year: 11.28%, Since Inception (May 29, 2009): 11.81%. ZSP Annualized Performance: 1-year: -12.63%, 3-year: 8.84%, 5-year: 10.67%, 10-year: 15.63$, Since Inception (November 14, 2012): 15.89%.

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