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Do you need to do anything to protect your portfolio from a weak Canadian dollar? Certain ETFs may help.
While recent moves from the Bank of Canada and the U.S. Federal Reserve primarily influence borrowing costs, they’ve also contributed to a sharp divergence in currency exchange rates. Specifically, the Canadian dollar has depreciated significantly against the U.S. dollar. When interest rates in Canada drop more aggressively than those in the U.S., the yields on Canadian assets become less attractive to investors everywhere, prompting capital outflows. Meanwhile, higher U.S. rates make U.S. dollar–denominated assets more appealing, strengthening the greenback. The impact for Canadian investors is clear: U.S. stocks are now even more expensive to access.
Beyond paying brokerage commissions/spreads for currency conversions, you’re also getting fewer U.S. dollars for every Canadian dollar you exchange. Fortunately, exchange-traded funds (ETFs) offer several ways to hedge against this weakening Canadian dollar. Here’s a look at some options to consider.
The first option, which you’re likely already exposed to in your portfolio, is unhedged U.S. equity ETFs. Here’s how it works:
Vanguard S&P 500 Index ETF (VFV) is a popular one. It holds the USD-denominated Vanguard S&P 500 ETF (VOO) but does not use derivatives to cancel out currency fluctuations between U.S. and Canadian currencies. As a result, when the U.S. dollar strengthens, the price of VFV rises beyond just the movements of the S&P 500 index.
Why? Because VFV is denominated in Canadian dollars, while its underlying assets are in American dollars. When the USD appreciates, those USD-denominated holdings are worth more in Canadian dollars. This currency effect is why VFV has outperformed its currency-hedged counterpart, the Vanguard S&P 500 Index ETF (CAD-hedged) (VSP), over the last decade.
Over a 10-year trailing time frame, as of December 31, the U.S. dollar generally appreciated versus the Canadian dollar, boosting VFV’s total NAV return to 15.15% compared to VSP’s 11.59%. So, if you already own VFV or another unhedged U.S. equity ETF, you’re inherently protected against a weaker CAD and even stand to benefit from a stronger USD.
However, keep in mind that the reverse is also true. If the CAD strengthens and the USD depreciates, VFV could lose additional value beyond the movements of the S&P 500 index. (Read: “Is VFV a good buy?”)
If you’ve ever used Norbert’s Gambit at your brokerage to cheaply convert Canadian money into American, you’re likely already familiar with the Global X US Dollar Currency ETF (DLR). If not, know that the process is pretty simple: you buy DLR with Canadian money, request your brokerage to “journal it over” to the USD-denominated DLR.U, and then sell DLR.U for U.S. dollars.
That said, DLR isn’t limited to currency conversion. It can also serve as a cash management tool. By holding DLR, you’re effectively going long on the U.S. dollar, while earning the risk-free rate. Currently, it pays a 4.44% annualized distribution yield.
Alongside the yield, you’re also exposed to currency movements. If the USD appreciates against the Canadian dollar, DLR’s price rises. Conversely, if the Canadian dollar strengthens, DLR’s price declines. Think of it as a “USD high-yield savings account” but denominated in Canadian dollars and traded as an ETF.
A caveat, though: DLR comes with a relatively steep management expense ratio (MER) of 0.59%, so it’s worth considering if its yield and currency exposure are worth its pricey fees.
Long-term investors may want to ignore short-term currency fluctuations. As of Jan. 29, the USD/CAD exchange rate sits high at 1.4459, but historically, it’s seen dramatic swings.
Back in September 2007, for instance, the USD/CAD exchange rate hit 0.9492. Yes, for newer Canadian investors reading, there was a time when the Canadian dollar was stronger than the greenback.
Exchange rates naturally fluctuate, and trying to predict their movements is a fool’s errand. If you think you can successfully do so, don’t bother investing—just trade forex full-time! For the rest of us, though, the key takeaway is that these highs and lows are cyclical.
If you own a broadly diversified portfolio of low-cost ETFs, the best move is often no move: sticking to your investment plan, tuning out the noise and fear about a falling loonie, and resisting the temptation to tinker with things.
Remember, taking unnecessary action can end up costing you more than doing nothing.
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