Winter 2023

Want Better Control Over Your Currency Exposure? Think ETFs.

To hedge or not to hedge? Erika Toth, Director, Institutional & Advisory, BMO ETFs, tackles that question and discusses how ETFs can be a flexible and effective tool for managing currency risks.

Jan. 17, 2023

Often, when family offices and investment counselors invest outside of Canada for their clients, they do so with securities on foreign exchanges. But there’s another option worth considering: ETFs.

ETFs can help practitioners maintain their desired exposures while managing currency (and even taxation) risks more precisely. And as the ETF business has grown significantly over the last decade, investors have more flexibility than ever when it comes to currency exposures. For clients looking for U.S. exposure, BMO will often offer Canadian dollar-hedged, unhedged, and US dollar (USD) purchase options. Similarly, for developed markets outside of North America, there is often a choice of hedged or unhedged. Emerging markets (EM) products, on the other hand, are typically only offered unhedged. This is because EM is comprised of many different currencies, some of which are illiquid; their pairs may not trade frequently enough with the Canadian dollar (CAD) or USD to construct a reliable hedge. In any discussion of currency risks, it’s important to keep in mind that currency values can be affected by many different factors: interest rate movements, government stimulus, energy and commodity prices, relative strength versus other investments, and levels of international investment.

ETFs can help practitioners maintain their desired exposures while managing currency (and even taxation) risks more precisely.

For an example of the currency flexibility benefits that ETFs provide, look no further than this past year. From the start of 2022 to the end of December, if you had invested in ZUE, the BMO S&P 500 Hedged to CAD Index ETF (ticker: ZUE), your return would have been -19.41%. However, investors anticipating a strong USD would have purchased the unhedged BMO S&P 500 Index ETF (ticker: ZSP), which ended up returning -12.63% for the year. In other words, the USD strengthened versus the CAD, which is typical in a risk-off market like the one we’ve experienced over the past 12 months.1

Taking a longer-term view, as the chart below shows, from 2005 up until the end of 2021, Canadian investors were typically better off unhedged to the USD. The result over that time frame? Slightly better annualized returns, and lower risk (standard deviation).

Current View

  • 5-year average for CAD/USD is $0.77
  • How much should I hedge? Generally, many Canadians look to hedge below $0.70 and seek USD exposure when it moves above $0.85
S&P 500
(Currency Hedged)
S&P 500
(Currency Unhedged)
Annual Currency Returns,
Avg Standard Deviation13.1610.68
Average Return11.4711.87

Source: Bloomberg, December 31, 2021. For illustrative purposes only.

To hedge or not to hedge?

So, when should you hedge? One rule of thumb is to hedge back to Canadian dollars around the US$0.70 mark (CA$1.42) and seek long USD exposure (unhedged) above US$0.85 (CA$1.18).

So far in 2023, the CAD has strengthened versus its greenback counterpart: investors in ZSP have participated in returns of 2.98%, and ZUE, 3.89%.2

For clients investing in European markets, those who did so on a CAD-hedged basis in 2022 have so far significantly outperformed their unhedged counterparts. For example, the BMO Europe High Dividend Covered Call Hedged to CAD ETF (ticker: ZWE) had a total return of -0.10% up to end of December 2022, compared to the unhedged BMO Europe High Dividend Covered Call ETF (ticker: ZWP), which returned -0.99%. This has been a consistent trend for these products since ZWP’s inception in 2018.3

The big takeaway? ETFs can offer investors the opportunity to be tactical and execute desired portfolio changes in a seamless manner.

Further hedging considerations:
1. Consider the time horizon of the investment. For equity holdings with a long-term horizon, unhedged USD exposure is generally preferred, for the reasons cited above — better annualized returns and potentially lower risk. However, if the time horizon is shorter, or if much of the client’s portfolio is already unhedged, the investor may opt for a CAD-hedged exposure. This is especially attractive if the timing of the investment occurs after a year where the USD has already strengthened considerably and is near the top of its historical range.

2. Consider the asset class’s historical volatility. Fixed income is often treated differently when it comes to the currency decision. This is because the standard deviation of foreign bonds is lower than the volatility of the foreign currency itself. Because bond investors are typically seeking to reduce volatility and have more predictable returns, many opt to strip currency out of the equation entirely. 

Annualized Volatility: Bloomberg Global-Aggregate Total Return Index (Unhedged) vs. Bloomberg Global-Aggregate Total Return Index (Hedged) – CAD

Annualized Volatility (Standard Deviation)
Hedging Effect6.16

Source: Bloomberg, January 1, 2001 to December 31, 2022. For illustrative purposes only.

3. Future cash flow needs. Practitioners working with snowbird” clients who have expenses in USDs will want to have cash flow-producing investments that are denominated in greenbacks. These family offices should consider using .U ETFs, which trade in USD but are listed on the Toronto Stock Exchange. Their benefits include:

  • .U ETFs are considered a Canadian-domiciled trust and not U.S.-situs assets
  • No U.S. Estate Tax liability
  • No T-1135 filings

ETFs offer investors the opportunity to be tactical and execute desired portfolio changes in a seamless manner

ETFs, currency exposure, and estate taxes

Typically, wealthy families have significant U.S. assets and, as a result, have embedded U.S. Estate Tax liabilities and exposure to fluctuations in the USD/CAD exchange rate. ETFs can help manage currency exposures and minimize a client’s exposure to U.S.-based assets, thereby minimizing U.S. Estate Tax liabilities.4

It may be cleaner to hold U.S. assets in an ETF than it would be to hold them directly because a Canadian-listed ETF is a Canadian trust, so the investment might be considered Canadian for U.S. Estate tax purposes, even if all the holdings are in the U.S. or elsewhere.

Our extensive selection of Canadian-listed hedged and unhedged ETFs gives investors the power to choose their exposure to the U.S. markets with or without USD exposure. 

BMO also offers USD-denominated ETFs that give clients exposure to U.S. markets in a Canadian Domiciled Trust structure that may not increase U.S. Estate tax liability. For example, a $10 million USD investment in ZSP.U, the BMO S&P 500 Index ETF (USD Units) (ticker: ZSP.U), provides exposure to large cap U.S. stocks without increasing U.S. Estate Tax liability — in other words, there might not be a connection to the IRS.

Another consideration for 2023 and beyond? ETFs as tax loss selling tools

Over the last several months of 2022, we had numerous conversations with clients holding individual U.S. names where the client was either in a capital loss position or simply wanted to hedge their currency risk going forward while maintaining exposure to a particular sector. In these situations, the clients benefited from moving into a Canadian-listed, CAD-hedged ETF.

Investors may also move from a CAD-hedged product to an unhedged product. This may be considered an actual disposition and might be acceptable for tax loss harvesting.4

Please note, this should not be construed to be legal or tax advice, as each client’s situation is different. Please consult your own legal and tax advisor.

Reach out to your regional Institutional BMO ETF Specialist for more information on how we can help you manage your currency and tax risks.

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%.

2 Morningstar, as of January 162023.

3 BMO Global Asset Management, as of December 31, 2022. ZWE Annualized Performance: 1-year: 0.10%, 3-year: 3.10%, 5-year: 4.00%, Since Inception (March 2, 2018): 6.01%. ZWP Annualized Performance: 1-year: -0.99%, 3-year: 2.42%, Since Inception (March 2, 2018): 2.74%.

4 BMO recently sought a legal opinion which confirmed that switching from a hedged to an unhedged strategy in the same index is an acceptable way to harvest a tax loss while maintaining exposure. It is an important consideration because ETFs can be used to toggle easily between currency exposures to manage clients’ tax strategies. This type of flexibility is not possible with stocks, so the opinion provides another example of how ETFs allow for greater control in client relationship management.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

The viewpoints expressed by the authors represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. Past performance is no guarantee of future results. The statistics in this update are based on information believed to be reliable but not guaranteed.

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

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