While hedging protects against a volatile home currency, it often sacrifices the very diversification that makes global investing attractive.

The Mechanics of the Global Portfolio

Diversification is frequently cited as the only free lunch in investing. By owning assets across the globe, an investor can increase expected returns while simultaneously decreasing expected volatility. However, global investing introduces a secondary layer of risk that many investors overlook until it works against them: currency exposure. When you buy an international stock, you are making two distinct bets. You are betting on the performance of the company in its home market, and you are betting on the value of that country’s currency relative to your own.

Consider a Canadian investor holding an S&P 500 index fund. If the American stock market rises by 10 percent, but the U.S. dollar simultaneously drops by 10 percent against the Canadian dollar, the investor’s net return is zero. To mitigate this, some opt for currency hedging—a financial strategy designed to lock in the exchange rate and isolate the performance of the underlying asset. While this sounds like a logical safeguard, the long-term reality of hedging is far more nuanced than a simple insurance policy.

The Illusion of the Right Answer

The temptation to hedge usually peaks when an investor’s home currency is weak. It is easy to look backward and see how a hedge would have saved a portfolio from a strengthening local dollar. Yet, multiple research papers have concluded that the long-term effects of currency hedging on portfolio returns are fundamentally ambiguous. Without the ability to accurately predict future currency fluctuations—a feat few, if any, can achieve consistently—there is no evidence of a universal 'right' answer.

Historical data supports this neutrality. In their 2016 study of long-term asset returns, Dimson, Marsh, and Staunton analyzed real exchange rates globally from 1900 to 2015. They found that while currencies were incredibly volatile, they did not exhibit a long-term upward or downward trend over the 115-year period. Essentially, over a long enough horizon, you are not necessarily better off with exposure to one currency over another. Similarly, a 2004 study by Meir Statman found that the realized risk and return of hedged and unhedged portfolios over a 16-year period were nearly identical.

Consumption vs. Diversification

If the data suggests that hedging doesn't reliably increase returns, why do it at all? The answer lies in the purpose of the money. Most people invest to fund future consumption, and most people consume in their local currency. For a Canadian, rent, groceries, and taxes are paid in Canadian dollars. Hedging a portion of a portfolio can help ensure that the wealth generated by global equities translates predictably into the currency required for daily life. It anchors a portion of the portfolio to the investor's economic reality.

However, hedging everything creates a new problem: it eliminates the diversification benefit that foreign currency provides. Currencies often move in ways that are uncorrelated with equity markets, providing a buffer during specific types of economic shocks. By hedging 100 percent of your foreign exposure, you are essentially doubling down on your home country’s economic fate. If your local economy suffers and your currency devalues, you lose the 'cushion' that unhedged foreign assets would have provided.

A Common Sense Path Forward

In the absence of a clear mathematical winner, the best approach is one of moderation and consistency. If you choose to hedge, avoid the extreme of hedging your entire portfolio. A common-sense middle ground is to hedge no more than 50 percent of your foreign equity exposure. This allows you to keep some returns aligned with your local consumption needs while retaining the structural benefits of currency diversification. If you prefer not to hedge at all, that is also a perfectly valid strategy supported by historical data.

The most critical factor is not the specific percentage you choose, but your ability to stick with it. Tactical hedging—trying to flip between hedged and unhedged positions based on market news—is a form of active management that usually results in higher taxes and fees. There will inevitably be years when your chosen strategy feels wrong. If the Canadian dollar rises, you will wish you were hedged; if it falls, you will wish you weren't. The worst mistake an investor can make is switching strategies in response to these cycles. Pick a strategy that aligns with your long-term goals and stay the course through the inevitable fluctuations.