As a Canadian investor buying into the global stock market, there is always one extra wrinkle to think about: currency exchange rates. That becomes especially relevant when you buy U.S. or international stocks.
What many investors do not realize, though, is that even Canadian-dollar exchange-traded funds (ETFs) can still be affected by foreign currency fluctuations behind the scenes. In other words, just because an ETF trades in Canadian dollars does not necessarily mean your returns are insulated from currency swings.
Fortunately, there are ways to reduce that volatility using certain ETF structures. You just need to know where to look. Here is what Tax Free Savings Account (TFSA) investors should know about protecting their portfolios from exchange rate swings.
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How currency swings affect your ETF returns
Suppose you own an ETF tracking the S&P 500 Index. Even if that ETF trades in Canadian dollars on the Toronto Stock Exchange, the underlying stocks themselves are still priced in U.S. dollars. That creates an additional layer of return tied to currency movements.
For example, if the U.S. dollar strengthens against the Canadian dollar, Canadian investors can actually see returns boosted beyond what the underlying stocks themselves generated. That happens because those U.S.-dollar assets convert back into more Canadian dollars.
The opposite can also happen. If the Canadian dollar strengthens relative to the U.S. dollar, Canadian investors may face a headwind even if the underlying U.S. stocks perform well. In that sense, currency exposure acts as a bit of a double-edged sword. Long term, these fluctuations often balance out.
Personally, I do not entirely mind this effect because during periods of market stress, investors often rush toward the U.S. dollar as the world’s reserve currency. That can create a partial “flight to safety” effect that offsets some equity market weakness for Canadian investors. Still, in the short term, currency swings can add additional volatility that some TFSA investors would rather avoid.
One way to reduce currency volatility
One solution is using a currency-hedged ETF. A good example is the Vanguard S&P 500 Index ETF (CAD-hedged) (TSX:VSP). VSP still tracks the S&P 500 Index, but it uses derivatives to help mitigate fluctuations between the Canadian and U.S. dollar.
Practically speaking, that means if the U.S. dollar suddenly surges, VSP will not receive the same additional currency boost that an unhedged ETF might enjoy. On the other hand, if the Canadian dollar strengthens sharply, VSP is designed to protect investors from seeing returns reduced purely because of exchange rate movements.
The ETF remains fairly inexpensive, charging just a 0.09% expense ratio. Investors should note, however, that the trailing 12-month yield of roughly 0.89% has already been reduced by the unavoidable 15% U.S. foreign withholding tax applied to dividends inside a TFSA.
For investors who want simpler exposure to the U.S. market without the extra currency volatility, though, a hedged ETF like VSP can still be a useful part of your TFSA portfolio.
