ETFs and Funds Investing

Should Canadian Investors Hedge US Dollar Exposure?

After constructing a well-diversified portfolio of Canadian and US companies – using a combination of individual stocks and ETFs – you look at your portfolio’s currency exposure and wonder: “Should I hedge or not?”

I believe there are reasons for and against hedging US dollar exposure, many of which investors fail to consider.

Most investors incorrectly base their decision to hedge US dollar exposure on their view of the US dollar. While it makes intuitive sense that if one is bullish on the US dollar they’d want unhedged exposure, I believe this is the wrong way to execute on this view.

Some Canadian investors might have 30, 40%+ of their equity holdings allocated to a diverse basket of US companies. They’ve committed a lot of time to ensure individual exposures aren’t excessive and spread across a range of sectors to reduce the risk of one individual weak holding making a significant impact on portfolio performance.

Yet, after all that careful effort they leave their entire US equity position exposed to a single factor: the US dollar. While there may be some nuances (e.g. some US companies will benefit from a weak US dollar), a decline in the US dollar would negatively affect the entire 30, 40%+ US equity position. This is a massive overexposure to a single risk factor.

By leaving a large portion of a portfolio exposed to a single factor investors are taking on significant risk. Many people fail to recognize this.

Historical Canadian dollar performance

If you were to ask Canadian investors during the mid 2000s about US stocks, most would say they stay far away. Why? Because during that time the Canadian dollar appreciated significantly against the US dollar, wiping out investment returns. At that time, currency risk was at the forefront of their minds because they had just experienced its painful effects. Between 2002 and 2007 (a 5 year period!) the Canadian dollar appreciated roughly 60% against the US dollar.

Note: Many investment practitioners argue that CAD/USD is a wash over the long run. The chart below shows that today’s level is close to where it was almost 30 years ago. What this argument fails to appreciate is that not all investors have a 30 year time horizon. An investor with a 5 year time horizon (note that many investors behave like they have 1 year time horizons) would have either experienced a massive tailwind or a massive headwind due to USD exposure. Not a gamble people should take as they approach real-world liabilities, like retirement. Also, the argument that CAD/USD is a wash over the long run erroneously assumes that exchange rates are mean-reverting and deviations are temporary. This is false.

Nobody knows where the USD/CAD exchange rate will head over the long run. Smart people have great guesses, but nobody truly knows. And it’s quite possible that CAD appreciates considerably again, for one reason or another. My point is the risk still exists and it always will.

By leaving a large portion of a portfolio exposed to a single factor investors are taking on significant risk. Many people fail to recognize this.

As with everything in finance and investing, there are multiple considerations. Nothing is black and white, and currency exposure is one of those things.

USD performance during crises

While overexposure to a single risk factor should be avoided in all portfolios, some exposure to the US dollar – due to its safe-haven status – does provide a portfolio cushion in times of crisis.

The chart below shows the level of CAD/USD during the recent crash. From December 2019 to March 2020, the Canadian dollar depreciated roughly 10% against the US dollar. This means that Canadians holding unhedged US assets would have benefited from a buffer.

Below, I’ve shown the performance of two TSX-listed US equity ETFs during that time period. Both are Vanguard S&P 500 Index ETFs, but VSP is currency hedged while VFV is not. You can see how the unhedged version of the ETF declined about 10% less than the hedged version, due to US dollar exposure. A similar narrative played out during the 2008 financial crisis.

So should I hedge or not?

Personally, when given the simple option I hedge. But overall, I might only be about 50% hedged.

My US exposure is attained using a combination of ETFs and individual stocks. Because it is much more time consuming to create my own hedges (e.g. using FX derivatives) my individual US stock holdings are unhedged. However, most TSX-listed US ETFs offer hedged and unhedged versions. In those cases, I buy the hedged ETF.

ETFs and Funds

Will Canadian Housing Market Collapse?

Some fun with charts:

Over the past year, the average house price in Toronto increased by almost $200,000! For those saving up for a down payment, they are another $200k behind.

Over the past several months, home prices in Toronto have gone vertical.

The IMF recently stated that overheating real estate is the greatest threat to Canada’s economy. The IMF provided their own fair value estimates for a variety of Canadian cities.

Toronto: Fair value is 28% below current prices

Vancouver: Fair value is 13% below current prices

Montreal: Fair value in line with current prices

Hamilton: Fair value is 30% below current prices

The proportion of median household income required to own an average home in Canada is approaching the Q2 1990 peak. Canadian real estate entered a long bear market in the early 1990s.

So when will Canadian real estate crash?

Or at least flatline for a while?

Honestly, who knows. People have been predicting a crash for a decade. Anyone who bought that narrative missed out on massive gains and is now likely priced out of the market.

Should I buy a house in Toronto?

I think most people should look at real estate as a rational purchase of shelter, not as an investment. This means taking a look at what you can truly afford relative to your assets and what you can earn while living in a certain geographic area. Compare that to renting (adjusting for square footage and perhaps some lifestyle benefits – e.g. a back yard) and you should have enough information to make a decision.

Unless you’re an investor, nobody should buy real estate with the hope or expectation that prices will continue to rise. Similarly, it is often foolish to hold off on a purchase hoping prices fall.

Of course, nobody wants to make a massive purchase only to watch prices fall 30% over the next couple years.

I don’t take any of this lightly. I understand that many people might run through the numbers and simply determine they can’t afford to live in Toronto, even if they must.

What’s quickly emerging is a two-tiered socio-economic strata – one with the financial means to afford a home and another that must resort to housing densification, cramming more family members into the same dwelling. The first group includes top decile earners and people with family money. The latter is everyone else.

Suggesting the latter group move to find more affordable accommodation is not the answer. The city needs tradesmen, social workers, waiters, day care workers, and so on. A city of lawyers and doctors doesn’t work (and would be a bore).

This is an urgent problem.

A huge portion of Canada’s economy is directly and indirectly connected to real estate. Real estate is the biggest risk to the Canadian economy and it is gutting the middle class. Either real estate prices collapse and hurl Canada into a massive recession or real estate prices continue to rise, further dividing the haves from have-nots.

The Federal and Provincial governments need to immediately create a task force to deal with this issue. While robust policy requires careful analysis before implementing, there are some obvious options that could quickly be executed. Namely, ban blind bids! People are bidding $100k, $200k+ over the next lowest bids driving prices artificially upward. Some people are even making offers significantly over asking not knowing there are no other bids!

Simply eliminating blind bids would cool the frenzy. Let’s start there.

ETFs and Funds Investing

Does ESG Investing Actually Achieve Anything?

Typical ESG investing (aka socially responsible investing, SRI investing, responsible investing, etc.) is a waste of time. It doesn’t achieve what many hope and believe.

ESG investment funds may be counterproductive and actually worsen the issues they are meant to fight.

Instead, many ESG funds only serve to pacify anxious investors who wish to decorate their portfolios with feel-good products. It’s sad to say because both ESG investment product manufacturers and investors usually have the best intentions. They want to do the right thing. Unfortunately, many fail to recognize their efforts are probably counterproductive and likely worsen the issues they are meant to fight.

As global interest in ESG investing rapidly grows, it is critical that investors understand how many ESG investment funds fall short of their implied objectives.

What is an ESG fund?

ESG funds are investment products (like mutual funds or exchange traded funds) that are constructed to feature environmental, social and corporates governance factors into their investment process.

Many ESG investment funds attempt to do this by excluding certain categories of sin stocks: guns, tobacco, porn, and so on. With growing concern about climate change, oil is increasingly at the top of the sin list.

The first problem with oil company exclusion is it’s very limited in scope. Oil companies don’t operate in a vacuum and are highly integrated within all sectors of the economy. They are financed by banks. They supply petroleum to chemicals and plastics manufacturers. Plastics are used in the production of millions of products. If boycotting oil companies, why not also their best customers and financiers?

It’s true that oil companies are at the heart of CO2 emissions and shutting down oil companies would stop the flow of petroleum based products throughout the economy. But excluding oil companies from ESG portfolios fails to shut anything down.

Companies have always had to work with various strata of investors who exclude certain investments based on a variety of characteristics. Value investors shun momentum stocks. Most of the world doesn’t invest in Canadian companies. Tobacco and gun stocks have been excluded from many large portfolios for decades. Yet, tobacco stocks, gun stocks and Canadian stocks have continued to perform as expected. Altria (formerly Phillip Morris) has a stellar long-run track record.

Is ESG investing profitable?

The exclusion of companies or sectors doesn’t affect performance. Research from South Africa’s period of Apartheid has shown that boycotting certain companies, sectors or countries is ineffective at altering share price performance.

Companies simply don’t need 100% of investors to be interested in their stock. There will always be a class of investors who don’t care about what they invest in as long as the returns are good.

In fact, the exclusion of certain companies from ESG portfolios may actually improve return prospects for those excluded companies. Perversely, if 80% of investors shunned Altria, for example, causing its share price to decline Altria’s expected future return would rise, attracting the remaining 20% of investors. A smaller pool of potential investors doesn’t change a company’s business prospects, and thus its intrinsic value. There will always be investors willing to capitalize on this. Moreover, without the burden of ESG-related business expenses, Altria’s intrinsic value may actually rise relative to other ESG-friendly companies.

Does ESG investing make a difference?

As conscientious investors abandon a company, the remaining class of financiers care less-and-less about the company’s practices. All things equal, this leaves the offending company to continue as it pleases, perhaps even creating a disadvantage for the ‘good’ companies that must operate under greater constraints.

Investors looking to force change would do better by adopting methods used by activist investors, like Carl Icahn. Activist investors take large stakes in companies they want to change. Shareholders, as company owners, have a right to board representation. The board hires company executives who then run the company.

To create change, investors must not distance themselves from companies with weak ESG practices. Instead, they must directly engage the companies they wish to change.

Research by the European Corporate Governance Institute shows that shareholder activism can create real change:

We study the nature of and outcomes from coordinated engagements by a prominent international network of long-term shareholders cooperating to influence firms on environmental and social issues. A two-tier engagement strategy, combining lead investors with supporting investors, is effective in successfully achieving the stated engagement goals and is followed by improved target performance. An investor is more likely to lead the collaborative dialogue when the investor’s stake in and exposure to the target firm are higher, and when the target is domestic. Success rates are elevated when lead investors are domestic, and when the investor coalition is capable and influential.

Abstract, “Coordinated Engagements”. January 2021

Given this perspective, ESG scores for investment funds (provided by various rating agencies) can be totally misleading. Based on current methodologies at many ratings agencies, to get a high score a fund must have minimal exposure to offending companies. As shown above, this can have a counterproductive result.

Don’t divest. Engage.

None of this is easy. However, if institutional investors (which represent individual investors) combine efforts and own enough of a company to engage the board they can enact real change. This is not an unusual practice, as investors have banded together many times in the past.

As public concern over climate change grows, there will likely be enough energy to make a real difference. However, it is critical that efforts are directed correctly, away from feel-good ESG products and into activist ESG funds.