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Protecting your portfolio from currency exchange rate risk

Our loonie's fortunes can affect your investments. While cross-border shoppers and vacationers are happy when our dollar is strong, if you've been holding U.S. and other foreign investments it's not as much fun.

Thinking it would be better to just stay home with your money? If you're a long-term investor, it might not be the wisest move. There are advantages to going outside our borders. But managing currency risk is a key part of successfully capturing global growth opportunities.

Sizing up the currency impact

When you invest in foreign assets you take on currency risk; even if your investment doesn't move up or down in price, you can make or lose money depending on the direction the Canadian dollar is headed.

Short term, exchange rates can make unexpected moves. After peaking in November 2007 against the U.S. greenback, the Canadian dollar quickly reversed, losing 10% of its value in just a month. But over time these movements tend to even out. Studies of the Canada/U.S. dollar relationship have found the currency effect becomes insignificant if investments are held long-term, that is for 15 years or more.

The history of North American stock markets supports this conclusion. It's no coincidence that Canadian and U.S. equity funds have seen their fortunes reverse over the years. While Canada has shone with a rising loonie, the opposite was true for much of the 1990s. Then, the Canadian dollar was falling and the U.S. market usually came out on top.

Comparing currencies

If predicting the equity market's twists and turns is difficult, so is trying to figure out which way exchange rates will move. The loonie's impressive rise against the U.S. dollar in 2011 caught everyone's attention, but it might surprise you that our dollar hasn't come out ahead of other currencies like the Australian dollar or Swiss franc.

The Canadian Dollar: Better than most......but not all

The Canadian Dollar: Better Than Most......But Not All
CurrencyLoonie's Gain / Loss Since 2000
U.S. Dollar +44%
British Pound +41%
Japanese Yen +17%
Euro (European Union) No change
Australian Dollar -9%
Swiss Franc -11%
Source: based on data from Bank of Canada, Monthly Average of Exchange Rates (2000 & 2010)

The point is, currencies don't all move the same way. Having too much of your money in the wrong place at the wrong time can weigh down your investment returns.

Protection from exchange rate risk

So how can you reduce volatility and protect the overall value of your portfolio from exchange rate risk?

Strategy #1: Diversification – the natural hedge

One way is by holding a basket of investments denominated in different currencies. This diversified approach is also known as using a "natural hedge".

Global equity and global balanced funds* are examples of investments that often use a natural hedge strategy. By owning securities from all over the world, a fund manager relies on the movements of various currencies to offset each other, minimizing their effect.

So, if you hold a mix of Canadian, U.S. and foreign equities, domestic and global bonds and a little cash, you can effectively manage your foreign exchange risk while creating a balanced portfolio.

Strategy #2: Currency-neutral funds

The idea behind currency-neutral funds is to eliminate currency risk altogether.

Using currency-forward contracts, swaps, options and other instruments, currency-neutral funds take foreign exchange out of the equation. Your returns are based on how the securities in the funds perform.

Investors using currency-neutral funds have been able to invest internationally without headwinds from a rising Canadian dollar. A random sample of U.S. index and large cap equity funds shows that in 2010 currency-neutral funds outperformed by a wide margin, returning an average of 12.4% versus 7.9% for identical unhedged funds.

For investors with a shorter time horizon concerned about currency fluctuations, or who just don't want to monitor exchange rates, currency-neutral funds can be sensible choice. But, they aren't ideal in all situations.

First, these funds are most valuable when the Canadian dollar is rising fast. But after the loonie's long advance, those gains may be mostly behind us.

With strong demand for resources and improving global growth, the loonie is likely to grind higher against the U.S. dollar for now. However, it's less likely to rise at the pace we've seen. Currency-neutral funds will still be winners if our money climbs further, but may deliver less punch.

On the other hand, currency-neutral funds don't help you if the Canadian dollar falls. In fact, they can leave you exposed to market risk as the financial crisis painfully showed.

Those who held unhedged U.S. equity funds were able to offset some of their losses from the U.S. dollar temporarily gaining strength relative to most other currencies, including the loonie. But owners of currency-neutral funds bore the full brunt of the decline.

Should the U.S. dollar regain its lustre or other world currencies appreciate against the Canadian dollar, a currency-neutral fund won't deliver the performance an identical, but unhedged, fund would. Because they're more complex to manage, you can also face higher expense ratios when investing. Your advisor can further explain the benefits of using currency-neutral funds and help you decide if they're the right choice for you.

More reasons to invest internationally.

With the muted performance U.S. and many foreign equity funds* have had, it's no wonder that we've seen a decline in their popularity.

According to figures from the Investment Funds Institute of Canada, U.S., global and international equities now make up less than 13% of net mutual fund assets, down from 32% in 2002 when commodities were just starting to attract attention. What may be lost are the reasons why investing state-side and overseas is still a sound approach.

Foreign markets are on sale. Commodity-rich nations and emerging economies are all the rage, leaving core equity markets like the U.S. and Europe out of favour. These markets are now relatively cheap for Canadian investors when priced in our dollars. Putting capital to work in these markets and "buying low" can pay off in the long run.

There are more opportunities beyond our borders. Canadian companies make up less than 4% of global equities, meaning more than 96% of investment opportunities are found elsewhere. By investing too much domestically you can miss out on growth and income opportunities abroad. For example, emerging economies like China, India and Brazil are advancing much faster than the developed world and promise to be a growing source of wealth for investors around the globe.

Our market's poorly diversified. The Canadian market is dominated by financials, energy and materials. With the resource bull market these sectors have grown to represent nearly 80% of the S&P/TSX Composite index's value.

On top of making for a more volatile, cyclical market, there's little room left here for important sectors like consumer staples, health care and technology. Investing only in Canada can leave holes in your portfolio. On the other hand, the U.S. market is deep in these industries which can add important balance.

Markets don't always move together. Although world equity markets fell with a collective thud during the financial meltdown, it was in the face of what could turn out to be a once-in-a-generation crisis. Normally markets move based on their own fundamentals which vary across economies and over time.

Zigging and zagging

As these numbers show, stocks markets carve their own path (measured in U.S. dollars)

As these numbers show, stocks markets carve their own path (measured in US dollars)
Investment Return
Market1 Year5-Year Average
Thailand 39.0% 13.8%
Korea 28.2% 7.0%
Nordic countries 20.5% 3.4%
Canada 19.7% 7.4%
Germany 17.2% 2.8%
United States 13.5% 0.8%
China 6.4% 14.3%
Israel -9.5% 6.3%
Greece -30.9% -18.3%
Source: MSCI Barra, MSCI Index Performance, April 2011

Having a broad mix of investments from different parts of the globe increases the chance that at least some of your investments will perform well at any given time, reducing volatility. For example, when oil, copper and other commodities are hot, Canada is likely to outperform. When they're weak, other markets are likely to lead.

Note: this article was written in 2011. However, the principles of managing currency risk remain. Contact us to learn more about how to manage currency risk in your portfolio and take advantage of the opportunities the global economy offers.

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*Mutual funds are offered through Credential Asset Management Inc. Mutual funds and other securities are offered through Credential Securities, a division of Credential Qtrade Securities Inc. Credential Securities is a registered mark owned by Aviso Wealth Inc.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Unless otherwise stated, mutual fund securities and cash balances are not insured nor guaranteed, their values change frequently and past performance may not be repeated.

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