Last year, many Canadian investors were punished for hedging the United States dollar (USD) risk exposure in their portfolios. However, we’re witnessing a reverse trend so far this year, where hedgers are seeing better returns, as illustrated in the chart below.

S&P 500 Total Return Index vs. the Canadian Dollar (CAD) Hedged Version of the S&P 500 Total Return Index

Source: Morningstar Direct as at July 31, 2016.

The USD/CAD relationship is an extremely important one for Canadian investors. The USD has historically been inversely correlated to Canadian equity returns. If there’s a shake-up in energy prices or economic issues with the Canadian dollar, you can expect the USD to appreciate vs. the CAD, significantly eroding Canadian equity returns.

For this reason, investors in U.S. equities (which make up the largest swath of international equities in Canadian portfolios) should probably un-hedge their exposure because it diversifies their portfolio. As well, hedging is expensive and not a very reliable source of returns. However, if you’re convinced that the Canadian dollar will generate better returns than the foreign currency being invested in, then hedging makes sense.

The odd mechanics of ETF hedging

In order to hedge the Canadian currency, ETFs must use currency forwards. Even on an extremely liquid futures contract like USD/CAD, the mechanics of buying and selling currency forwards creates additional costs.

As well, these ETFs will have a higher degree of tracking error — not only to the locally denominated index — but sometimes to the index they are tracking. The index methodology of CAD-hedged indexes is almost always set on a monthly basis at an end-of-month currency spot price. Since currencies don’t stay static throughout the month, there can be significant deviation between the currency return reported by the index and what’s actually achieved by the ETF. This underscores that investors should avoid hedging strategies unless there is significant currency risk in the CAD/local currency relationship.

Doing it yourself with currency ETFs

If you’re of the view that the USD/CAD relation could change dramatically, you can simply buy a currency ETF like the Horizons U.S. Dollar Currency ETF (DLR) or the Horizons Canadian Dollar Currency ETF (CAN).You can use these ETFs to get direct exposure to either the USD reflected in Canadian dollars or to CAD reflected in U.S. dollars. These types of ETFs are ideal if you have a fixed asset allocation that you don’t want to mess around with.

Delegate your hedging with actively managed ETFs

Given the excess returns that can be generated through currencies, we’re seeing a lot of strategies that actively manage currency exposure. Recently, we launched an actively managed currency ETF strategy, the Horizons Global Currency Opportunities ETF (HGC). It invests in a universe of 32 currencies with the express purpose of outperforming the Canadian dollar. Most successful global strategies today have dynamic or active currency management. For example, our Horizons Active Global Dividend ETF (HAZ) has generated approximately 5% additional returns over the last year by tactically hedging, when necessary, its international equity exposure. Similarly, the Horizons Global Managed Opportunities ETF (HGM) uses currency management as a key driver of its returns.

The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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When It Comes to Skews, The Devil is in the Details

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Commissions, management fees and expenses all may be associated with an investment in exchange traded products managed by Horizons ETFs Management (Canada) Inc. (the "Horizons Exchange Traded Products"). The Horizons Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. The prospectus contains important detailed information about the Horizons Exchange Traded Products. Please read the relevant prospectus before investing.

The Horizons Exchange Traded Products include our BetaPro products (the “BetaPro Products”). The BetaPro Products are alternative mutual funds within the meaning of National Instrument 81-102 Investment Funds, and are permitted to use strategies generally prohibited by conventional mutual funds: the ability to invest more than 10% of their net asset value in securities of a single issuer, to employ leverage, and engage in short selling to a greater extent than is permitted in conventional mutual funds. While these strategies will only be used in accordance with the investment objectives and strategies of the BetaPro Products, during certain market conditions they may accelerate the risk that an investment in sahres of a BetaPro Product decreases in value. The BetaPro Products consist of our 2x Daily Bull and 2x Daily Bear ETFs (“2x Daily ETFs”), Inverse ETFs (“Inverse ETFs”) and our BetaPro S&P 500 VIX Short-Term Futures™ ETF (the “VIX ETF”). Included in the 2x Daily ETFs and the Inverse ETFs are the BetaPro Marijuana Companies 2x Daily Bull ETF (“HMJU”) and BetaPro Marijuana Companies Inverse ETF (“HMJI”), which track the North American MOC Marijuana Index (NTR) and North American MOC Marijuana Index (TR), respectively. The 2x Daily ETFs and certain other BetaPro Products use leveraged investment techniques that can magnify gains and losses and may result in greater volatility of returns. These BetaPro Products are subject to leverage risk and may be subject to aggressive investment risk and price volatility risk, among other risks, which are described in their respective prospectuses. Each 2x Daily ETF seeks a return, before fees and expenses, that is either 200% or –200% of the performance of a specified underlying index, commodity futures index or benchmark (the “Target”) for a single day. Each Inverse ETF seeks a return that is –100% of the performance of its Target. Due to the compounding of daily returns a 2x Daily ETF’s or Inverse ETF’s returns over periods other than one day will likely differ in amount and, particularly in the case of the 2x Daily ETFs, possibly direction from the performance of their respective Target(s) for the same period. Hedging costs charged to BetaPro Products reduce the value of the forward price payable to that ETF. Due to the high cost of borrowing the securities of marijuana companies in particular, the hedging costs charged to HMJI are expected to be material and are expected to materially reduce the returns of HMJI to unitholders and materially impair the ability of HMJI to meet its investment objectives. Currently, the manager expects the hedging costs to be charged to HMJI and borne by unitholders will be between 10.00% and 45.00% per annum of the aggregate notional exposure of HMJI’s forward documents. The hedging costs may increase above this range. The manager will publish, on its website, the updated monthly fixed hedging cost for HMJI for the upcoming month as negotiated with the counterparty to the forward documents, based on the then current market conditions. The VIX ETF, which is a 1x ETF, as described in the prospectus, is a speculative investment tool that is not a conventional investment. The VIX ETF’s Target is highly volatile. As a result, the VIX ETF is not intended as a stand-alone long-term investment. Historically, the VIX ETF’s Target has tended to revert to a historical mean. As a result, the performance of the VIX ETF’s Target is expected to be negative over the longer term and neither the VIX ETF nor its target is expected to have positive long-term performance. Investors should monitor their holdings in BetaPro Products and their performance at least as frequently as daily to ensure such investment(s) remain consistent with their investment strategies.

*The indicated rates of return are the historical annual compounded total returns including changes in per unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. The rates of return shown in the table are not intended to reflect future values of the ETF or returns on investment in the ETF. Only the returns for periods of one year or greater are annualized returns.