To hedge or not to hedge, that's the question

One of the most disciplined investors I have admired for some time is the Torontonian Francis Chou. Below he writes about currency hedging. (excerpt from the 2007 Unitholder letter-- get the full pdf at choufunds.com)

Hedging Currency for the long term

We are long term investors and, in general, our bias has been to concentrate on stock
selections and not worry about currency fluctuations. With years like 2007, the question
arises as to whether there have been major disparities in annualized returns over the long
term between a hedged portfolio and an unhedged portfolio; in other words, does one offer
more advantageous performance results during currency fluctuations? Two studies, one
covering the period from 1975 through 1988 and the other from 1988 through 2003, confirm
that with respect to the long term there have been no material differences in returns.
The study for the period from 1975 to 1988 was conducted by Lee Thomas, and presented in
a paper titled “The Performance of Currency – Hedged Foreign Equities”. I first read about
his findings in an article written by Tweedy Browne, a famous value investment firm in the
United States. Excerpts from the Tweedy Browne article appear below.
“A study by Lee Thomas, ‘The Performance of Currency – Hedged Foreign Equities’,
examined the performance of equities in Germany, France, Canada, the United Kingdom,
Japan and Switzerland from 1975 through 1988, comparing unhedged results to hedged
results for a U.S. dollar investor. These six stock markets accounted for about 88% of the
world market capitalization, excluding the United States. The study used FT-Actuaries
Indices returns, included dividends and assumed that the beginning of each month the
investor hedged by selling forward (for U.S. dollars) for one-month delivery the foreign
currency value of his equity shares. Over the 1975 through June 1988 study period, the
compounded annual returns on hedged and unhedged foreign equities were 16.4% and
16.5% respectively.”

The study for the period from 1988 to 2003 was done by Meir Statman, and Glenn Klimek,
Professor of Finance at Santa Clara University. They wrote, “We examined hedged and
unhedged portfolios during 1988 - 2003 and find that their realized returns and risk were
virtually identical. Portfolio managers who care about the risk and expected returns of policy
portfolios could have chosen to hedge or not to hedge by the toss of the coin. The mean
monthly returns of unhedged global portfolios were higher than those of hedged ones in
eight of the 16 years from 1988 through 2003 and lower in the other eight…. The 8.53%
mean annualized return of the unhedged global portfolio was slightly lower than the 8.60%
mean annualized return of the hedged portfolio during the overall 1988-2003 period.”
While the effect on long term results may be statistically insignificant, on a year-to-year
basis, currency swings can truly distort results. These swings can be heart stopping,
particularly for our unitholders, and especially when the currency goes against them. This
was evident with the Fund in 2007. But in this situation the reactions were mixed. We
received a number of calls regarding the results. Investors from Niagara Falls on the U.S.
side of the border were quite pleased with the 2007 performance (+5.8%), whereas investors
just half a mile away, in Niagara Falls, Canada, expressed concerns about the Fund’s
performance (-10.2%).

We don’t know what the true value of the Canadian dollar is vis-à-vis the U.S. dollar but we
would hazard a guess that it is somewhere between 80 cents and $1.20. Therefore, we
believe that the Canadian dollar is trading in the range of fair value. However, on a short
term basis, it is subject to many variables such as the current price of energy, monetary and
fiscal policies of both countries, carry trades by currency speculators (they can swing it
either way by 30%) and so on.

When deciding to hedge vs. not hedge, it is only in hindsight that there can ever be certainty
that the right decision was made. It is virtually impossible to sustain any reliable degree of
success in predicting which way to go. When measured on a year to year basis we have been
wrong in the past and it is likely that we will be wrong again in the future. But there is little
need for concern. The ramifications of such hedging decisions should only affect short term
performance results for the Fund. We are long term investors and therefore, over the long
term, whether we ‘got it right’ or not should be immaterial.

Our bias at this time is ‘not’ to hedge because we believe that the Canadian dollar is trading
in the range of fair value. In the long run, it will be influenced significantly by energy prices.
Based on the latest trade figures, Canada’s trade with the world is at a deficit net of energy.
With the dollar at parity with the U.S. dollar, all the numbers from exports, tourism,
manufacturing and retail sales look appalling when compared to last year. The only time
where we may be inclined to hedge the currency is during a period of extreme
undervaluation. So for now, be prepared for a bit of a bumpy ride, and some extra volatility,
but take into account the results of the aforementioned studies which indicate that (at least in
the past) it all evens out in the long run. And remember, hedging currencies comes with a
cost…about 1% a year.