Most of us have, at some point, noticed how currency fluctuations impact our daily lives—like why a trip to the US or imported goods cost more when the Canadian dollar (CAD) is weaker. When the CAD shifts in value against other global currencies, the impact on our purchasing power is clear and generally easy to grasp—whether that ends up being in our favour or not.

But for many Canadian investors who wisely diversify their portfolios with global assets, including US and international companies, currency fluctuations play a less obvious, yet powerful, role. Beyond affecting your purchasing power, currency movements can also influence your investment portfolio—either boosting or eroding your investment returns. This article will explore how these currency movements affect your foreign holdings and help you understand whether limiting these impacts through 'hedging' is the right strategy for your portfolio.

How currency fluctuations impact investment returns

When you invest in foreign assets—like buying a US or international stock—you're essentially converting your Canadian dollars into the respective foreign currency to make the purchase. This leads to your investment having direct exposure to future currency fluctuations when compared to the Canadian dollar and introduces “currency risk.”

The true value of your investment, when you eventually convert it back to CAD, depends on two things:

1. How the asset performs in its local currency: Did the value of the foreign asset go up or down in its foreign currency?
   
   
2. The exchange rate between currencies: Did the CAD strengthen or weaken against that foreign currency since you invested?

Both these factors work together to determine your final return in CAD terms, and sometimes, the currency impact can be significant. 

Let’s consider the following example:

As illustrated above, currency fluctuations under the different circumstances had a significant impact on the investor’s return. An appreciating CAD against the USD would typically be celebrated by those looking to travel down south, but would detract from the performance of their US investment holdings.

What is currency hedging?

Currency hedging aims to neutralize or reduce the impact of these currency fluctuations on your foreign investments. In essence, it's a strategy designed to protect the value of your foreign assets from adverse currency movements, providing returns based on the underlying investment’s performance only.

This is typically achieved through financial instruments like forward contracts, which essentially lock in an exchange rate for a future transaction. For Canadian investors, the most common and accessible way to implement hedging is through specific currency-hedged ETFs or mutual funds. These funds use derivatives to mitigate currency risk, meaning your returns will primarily reflect the underlying asset's performance in its local currency, rather than being swayed by currency swings.

Should I hedge?

Deciding whether to hedge your foreign investments isn't a one-size-fits-all answer. It depends on several factors specific to your financial situation and investment goals.

Consider your investment horizon:

• Long-term (10+ years): For investments earmarked for longer-term goals, hedging may be less critical. Historically, long-term currency movements can be somewhat self-correcting, and the impact of short-term fluctuations tends to diminish over extended periods. 

Over an approximately 20-year period (ending June 30, 2025), the S&P 500's total return for Canadian investors averaged an annualized rate of 11.33% per year which exceeded its return of 10.72% in USD terms. This demonstrates that the CAD had weakened over the past two decades, which enhanced returns for an unhedged Canadian investor holding US assets. That said, over this time, you’ll notice that there were periods where the difference in returns was either negligible, or were not in favour of Canadian investors, reflecting the typical averaging out of currency impact over the long-term.

• Short-term (1-5 years): For investments with a shorter time horizon, hedging may be more appealing. Over shorter periods, currency movements can be more volatile and less likely to "average out," making the impact of an adverse swing more pronounced.