Impacts of currency fluctuations and currency hedging on returns

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adrian2
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by adrian2 »

longinvest wrote: 14 May 2017 20:45
adrian2 wrote: 14 May 2017 20:43 Costs are significantly higher for international bonds.
How so?
Over the counter trading, plus (AFAIK) there are more bonds than stocks (harder to replicate the index).
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

adrian2 wrote: 14 May 2017 20:51
longinvest wrote: 14 May 2017 20:45
adrian2 wrote: 14 May 2017 20:43 Costs are significantly higher for international bonds.
How so?
Over the counter trading, plus (AFAIK) there are more bonds than stocks (harder to replicate the index).
Vanguard has no problems replicating the bond index (and adding currency hedging on top). There's BNDX for U.S. investors, and the VBU/VBG combo for Canadian investors.

I don't think that costs are the main issue, for unhedged international bonds. Here are the more important issues that I see:
  • Currency fluctuations make unhedged foreign bonds unreliable for getting a fixed income, or keeping a relatively stable capital investment in Canadian dollars.
  • It's easier for a government to renege on its promises to foreign retail investors, than to domestic retail investors, if only for political reasons.
Let me say this again. A Canadian investing into a U.S. bond experiences risks that are not shared by a U.S. investor into the same bond. The volatility of the investment, for the Canadian investor, is not limited by the duration of the U.S. bond; it remains as arbitrarily volatile as the exchange rate between the Canadian and U.S. dollars.

The same might be less visible, but applies to stocks too. It's just that because stocks are volatile on their own that we don't see how significant the impact of currency fluctuations is on foreign stock investments.
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Re: Impacts of currency fluctuations and currency hedging on returns

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longinvest wrote: 14 May 2017 20:23 But, if you were to look at it from the other side, the picture is pretty bad. U.S. investors investing abroad have been experiencing pretty bad returns for the last 20 years. Here's a chart of U.S. bonds (VBMFX) in blue and World ex US stocks in red, since the inception of Vanguard's Total International Stock Index Fund (VGTSX):
If you think about it, I could make an argument that US investors should only care about the USD. With the USD being the world's reserve currency, they should stick with US investing, and mainly the S&P500 to get the benefit of all their multi-nationals. Was it Jack Bogle that said that? Why should Americans invest anywhere else?
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Re: Impacts of currency fluctuations and currency hedging on returns

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AltaRed wrote: 14 May 2017 23:25 If you think about it, I could make an argument that US investors should only care about the USD. With the USD being the world's reserve currency, they should stick with US investing, and mainly the S&P500 to get the benefit of all their multi-nationals. Was it Jack Bogle that said that? Why should Americans invest anywhere else?
So, if I understand well, investing is simple, after all. One just has to project the past into the future and invest accordingly, as it works most of the time. Until it doesn't, but nobody wants to hear about that!
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Re: Impacts of currency fluctuations and currency hedging on returns

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longinvest wrote: 14 May 2017 11:00 That sounds similar to Jack Bogle's contention that U.S. investors don't need international investments, because U.S. companies make a big part of their business abroad.
On this point I disagree with Bogle. If you believe in the underlying theory of indexing, which is purchasing a broadly based index based on market capitalization, why stop at your home country's border? Shouldn't it be applied to global market capitalization as well?
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

Peculiar_Investor wrote: 15 May 2017 07:46 why stop at your home country's border?
I have given a few reasons, in this thread, that justify not investing abroad in proportions of market capitalization. The main argument is that identical investments expose domestic and foreign investors to different risks, and the returns experienced by foreign investors are different, too, being significantly affected by currency fluctuations.

Does this justify not investing abroad at all? It depends. For me, it does justify not investing at all into foreign-currency denominated bonds, even though they are the largest asset class (bigger than foreign stocks). But, I am willing, on the other hand, to invest part of my stock allocation abroad, just not 97% of it.

Anyway, I certainly think that the risk and return argument opens the door for a rational investor to keep a home bias in his portfolio.
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

Let me add that if it was easy to cheaply and reliably remove the impact of currency fluctuations, it would be easier to justify investing abroad in proportions of market capitalization. One could then move the discussion to the more interesting topic of whether it's nominal or inflation-adjusted currency fluctuations that should be hedged. But, I think that we all agree that currency hedging is neither cheap nor reliable.
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by Peculiar_Investor »

We are starting to drift from the original topic, but since we seem to remain at least tangentially connected I'll continue this worthwhile discussion.
longinvest wrote: 15 May 2017 08:03
Peculiar_Investor wrote: 15 May 2017 07:46 why stop at your home country's border?
I have given a few reasons, in this thread, that justify not investing abroad in proportions of market capitalization. The main argument is that identical investments expose domestic and foreign investors to different risks, and the returns experienced by foreign investors are different, too, being significantly affected by currency fluctuations.
But that's a different reason than what you stated above
longinvest wrote: 14 May 2017 11:00 That sounds similar to Jack Bogle's contention that U.S. investors don't need international investments, because U.S. companies make a big part of their business abroad.
If U.S. companies make a big part of their business abroad, aren't some of those risks hidden within the results of the U.S. companies? If you read quarterly reports of large U.S. multinationals, they regularly state their revenues and earnings were hurt by foreign exchange impacts. Curiously they are never helped it seems, but I digress.

Bogle's basic premise is rather than selecting a subset of the market capitalization, you should purchase everything, i.e. the broad-based index based on market capitalization. I think Bogle's viewpoint on International shows his home country bias and he is making a performance call, which contradicts the basic premise of indexing. If Bogle is correct, should everyone just invest in U.S. broad-based indices regardless of where they live?

I know it's not his original thoughts on the matter, but this recent interview provides Bogle's rationale, Why Bogle Doesn't 'Do' International Investing
Jack Bogle wrote:So, I don't do international. And emerging markets is a little separate part of so-called "international." We're wonderful in America--we call non-U.S. funds international. Where's the U.S.? (Laughs.) They are really non-U.S. funds--non-U.S. portfolios. I probably talked about this a year ago. I say, "What are you buying?" There is such a thing as oversimplifying--this coming, of course, from the great simplifier. People say, "Buy the EAFE Index or the FTSE International Index." So, [ I tell people to drill down into that index]. What are you buying? Look behind the curtain. Your largest investment is Britain. Your second-largest investment is Japan. Your third-largest investment is France.

What, Christine, I ask you, is the possibility that those three nations are going to outpace the U.S. in terms of investment return in the next 10 years? I just don't think it's possible. And those countries may be the better ones. Each one has its own set of troubles. We've got plenty of troubles over here in the U.S. But at least we know that we have the most innovative economy, the most productive economy, the most technologically advanced economy, the most diverse economy in the world. And we also have shareholder protections that can be taken for granted.
What happens if we substitute 'three nations' with 'three sectors', say like Financial, Energy and Materials, i.e. the Canadian broad-based index. Doesn't it all start to sound like active investing and trying to pick the winners rather than accepting the market return?
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Re: Impacts of currency fluctuations and currency hedging on returns

Post by longinvest »

Peculiar_Investor,
Peculiar_Investor wrote: 15 May 2017 09:08 We are starting to drift from the original topic, but since we seem to remain at least tangentially connected I'll continue this worthwhile discussion.
I think that we're still on topic. My last two posts addressed the problems at heart of my initial post, which were that the returns of VFV are drifting away (on the positive side, luckily*) from the returns of the S&P 500, and that the use of currency-hedging to avoid this drift has proven both expensive (-1.55% per year over the last 10 years for XSP) and unreliable (what happened to XSP in late 2008 / early 2009).

* Some investors might see this as a good signal to rebalance some of their VFV holding into cheaper investments.
Peculiar_Investor wrote: 15 May 2017 09:08
longinvest wrote: 15 May 2017 08:03
Peculiar_Investor wrote: 15 May 2017 07:46 why stop at your home country's border?
I have given a few reasons, in this thread, that justify not investing abroad in proportions of market capitalization. The main argument is that identical investments expose domestic and foreign investors to different risks, and the returns experienced by foreign investors are different, too, being significantly affected by currency fluctuations.
But that's a different reason than what you stated above
longinvest wrote: 14 May 2017 11:00 That sounds similar to Jack Bogle's contention that U.S. investors don't need international investments, because U.S. companies make a big part of their business abroad.
Let me clarify: I only reported Jack Bogle's opinion; I never said that I agreed with it. On the contrary, I disagree with him on this.

Peculiar_Investor wrote: 15 May 2017 09:08 Bogle's basic premise is rather than selecting a subset of the market capitalization, you should purchase everything, i.e. the broad-based index based on market capitalization. I think Bogle's viewpoint on International shows his home country bias and he is making a performance call, which contradicts the basic premise of indexing. If Bogle is correct, should everyone just invest in U.S. broad-based indices regardless of where they live?
That would be a logical conclusion, effectively, if we agreed with Bogle's premise.
Peculiar_Investor wrote: 15 May 2017 09:08 What happens if we substitute 'three nations' with 'three sectors', say like Financial, Energy and Materials, i.e. the Canadian broad-based index. Doesn't it all start to sound like active investing and trying to pick the winners rather than accepting the market return?
Yes, it sounds like active investing. Bogle's opinion on bond investing (in the U.S.) also leans on the active side. He recommends to overweight corporate bonds because they have higher yields and he feels that the index has too much weight into Treasuries which are widely held by agencies and foreign countries. Actually, he seems to ignore that Vanguard's Total Bond Market Index Fund actually tracks a free-float index which excludes the weighting of these privately held securities.

I think that Jack Bogle has made a gigantic contribution to the world of investing by creating Vanguard and the first widely available index fund. But, that does not mean that I agree blindly with everything he says. I much prefer to reason about investing based on more formal grounds.

My main motivation for holding an index portfolio is William Sharpe's theorem. But, as I expressed in this thread, I don't think that it is obvious how to generalize Sharpe's argument across domestic and foreign markets.

Even with an all-domestic portfolio, it's far from obvious that all investors should strive to passively track the stocks/bonds ratio of the bond-and-stock market. It seems quite sensible, on the contrary, to let more personal concerns drive the stocks/bonds ratio in the portfolio of individual investors. Even Sharpe seems to agree with this as he wrote articles about how to do that while minimizing market impact (e.g. Adaptive Asset Allocation Policies).
Last edited by longinvest on 15 May 2017 10:18, edited 2 times in total.
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Re: Impacts of currency fluctuations and currency hedging on returns

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In a practical sense, I think the situation is somewhat different looked through the lens of an American. They have the reserve currency, they are the elephant in the room, they have the bulk of the multi-nationals, and technically have no reason to live, operate, or spend outside their home country. So home bias works for them with little to no consequences. I would likely do the same if I lived there..well, maybe dabble a bit in the Eurozone given that is the next largest market cap block with multi-nationals of their own.

It is a very different situation for a tiny market cap, and trading, country like Canada. The bulk of what we consume is subject to forex fluctuation, either directly such as gasoline prices, or indirectly via the shock absorber of an import distribution decision, e.g. autos. It would seem that hedging would disrupt that relationship and actually expose oneself more to currency fluctuations. IOW, if gaoline prices go up as the loonie goes down, I want unhedged USD which are now worth more to buy that more expensive gasoline. Still, I would not hold just 3% of my equities in Canada simply because I do spend more than 3% of my money on isolated Canadian goods and services.

I've always come to the conclusion there is no right answer so I rejoice? perhaps falsely? when the loonie goes down and my net worth goes up on paper, and grit my teeth when the loonie goes up, but recognize that my ex-Canada goods and services I buy should theoretically come down in price. Th truth is probably in between, or worse, I get screwed both ways due to retail markets taking advantage of consumers in forex moves.
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Re: Impacts of currency fluctuations and currency hedging on returns

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longinvest wrote: 14 May 2017 20:23 The problem I raised in the OP remains, though. In the short term, currency fluctuations can have a very significant impact on returns.
Yes but according to some studies, currency hedging of foreign equities actually increases volatility for Canadians: Increased volatility. So currency fluctuations are actually a good thing, in this light.

However I agree with you, obviously, that the fact that currency fluctuations have mostly evened out over 20 year periods in the past does not guarantee that the same result will be repeated in the future (fell free to amend the finiki article to your liking to reflect this :) ). But then the future in uncertain, in general: what the CAD will do over the next year, or decades, is anybody's guess. But so are bond and stock returns. Yet we still invest in stocks and bonds (or GICs).

I'm comfortable with our 42% unhedged foreign equities for now (all in registered accounts). I don't think replacing those by hedged equivalents, or Canadian stocks, to avoid currency fluctuations, makes much sense for us.
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Re: Impacts of currency fluctuations and currency hedging on returns

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Quebec wrote: 15 May 2017 10:46
longinvest wrote: 14 May 2017 20:23 The problem I raised in the OP remains, though. In the short term, currency fluctuations can have a very significant impact on returns.
Yes but according to some studies, currency hedging of foreign equities actually increases volatility for Canadians: Increased volatility. So currency fluctuations are actually a good thing, in this light.

However I agree with you, obviously, that the fact that currency fluctuations have mostly evened out over 20 year periods in the past does not guarantee that the same result will be repeated in the future (fell free to amend the finiki article to your liking to reflect this :) ). But then the future in uncertain, in general: what the CAD will do over the next year, or decades, is anybody's guess. But so are bond and stock returns. Yet we still invest in stocks and bonds (or GICs).

I'm comfortable with our 42% unhedged foreign equities for now (all in registered accounts). I don't think replacing those by hedged equivalents, or Canadian stocks, to avoid currency fluctuations, makes much sense for us.
I am with you on that. Close to 40% of our registered investments our in US securities and are unhedged. We spend 5 months in the US and currency fluctuations aren't an issue.
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Re: Impacts of currency fluctuations and currency hedging on returns

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My portfolio is about 45% ex-Canada and unhedged. Perfectly happy with that arrangment and will allow it to creep up even further as I disproportionately consume CAD for the bulk of my living expenses and thus let ex-Canada run (for the most part).
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Re: Impacts of currency fluctuations and currency hedging on returns

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AltaRed wrote: 16 May 2017 10:46 My portfolio is about 45% ex-Canada and unhedged.
My equities are 97% ex-Canada and unhedged. My fixed income (about a third of my portfolio) is all in CAD. As time goes on, I expect the proportion of fixed income to decrease. So both the proportion and the absolute value in other than CAD will increase (barring unexpected stock market crashes, medical emergencies, and the like).

Commenting on some of the discussion upthread, I see less reason to hold foreign bonds than foreign equities for purposes of diversification. The reason is that equities are generally much more volatile than FI, and so the benefits from diversification are greater. This is especially true in my case. I use FI as the "ballast" or "shock absorber" in my portfolio (in AR's words) and so I want my FI holdings to be safe from credit risk and inflation risk (there is little market risk, as I plan on holding to maturity.) Diversification into international bonds is unlikely to reduce those risks.

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Re: Impacts of currency fluctuations and currency hedging on returns

Post by kcowan »

George
I seem to detect that you are changing your strategy. Is this because you have been too cautious?
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Re: Impacts of currency fluctuations and currency hedging on returns

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I can see the logic for being overweight in the home market but limiting yourself to 3% of the world or even N America is, in my opinion, unjustified. Diversification is good; it reduces volatility without damaging return expectation. Therefore excluding a bunch of companies based on where their headquarters are is the opposite of good.

Currency fluctuations have a short-term effect; but long term firms with declining currencies in their home markets get a nice bump in profits which offsets the impact of currency movements on the share price in CAD.

And the argument that you should have stocks in the market where you live/consume does not seem logical. High inflation can easily combine with poor market return and recession in the home country at the time when foreign markets/economies could be fairing much better.
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Re: Impacts of currency fluctuations and currency hedging on returns

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Most of my equity portfolio is ex-Canada but I have been taking advantage of the low CAD to buy more here.

Given that we import so much, I think I will feel safer in retirement with a decent USD component in my income.
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Re: Impacts of currency fluctuations and currency hedging on returns

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kcowan wrote: 16 May 2017 18:29 George
I seem to detect that you are changing your strategy. Is this because you have been too cautious?
I have had roughly the same strategy for a dozen years. I have an absolute amount of FI as a target (indexed for inflation), a target I reached in late 2008 when RRBs went on sale. Since then, I have placed any new money into equities. Similarly, when I needed money (new car, new roof, daughter's wedding, loan (so-called) to brother-in-law)) I took the money out of equities. Since (a) I am still working part time and (b) markets have been increasing, that means equities have been increasing as a proportion of the total.

The main change in my strategy has been moving out of individual stocks and out of mutual funds, and into ETFs, which now more or less reflect world market caps. I consider this measure to be a reduction in volatility and costs.

You are right that my tolerance for risk has increased, or at least I think so. But perhaps that is because my liabilities (children's needs, shorter expected remaining life) keep decreasing. I have thought, on and off over the last few years, of reducing the absolute amount of FI. But every time I take that decision, I go and lie down for a while. :wink:

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Re: Impacts of currency fluctuations and currency hedging on returns

Post by kcowan »

Thanks George. I believe your evolution is similar to mine.
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