The currency effect
PART 9: Investing globally may be a smart way to diversify a portfolio and increase returns, but to maximize opportunities it's important to consider the impact of international currency fluctuations
With Canada's markets representing less than five per cent of the global economy, diversification through foreign investment reduces risk and increase returns. But over the short term, currency exposure can make gains difficult to realize - when the Canadian dollar rises, the value of investments denominated in other currencies declines.
To reduce this risk, some mutual funds use options, futures or forward contracts to 'hedge' against currency volatility. Most Canadian global and international funds are not hedged, as currency fluctuations are seen as balancing out over time, and in the short term can add as much as they subtract from returns. Understandably, that view has been questioned by investors stung by the Canadian dollar's rapid rise.
"The Canadian dollar went from $0.63 U.S. to over par in the past few years, and that made all foreign equity returns look pathetic relative to the Canadian market," says MFC Global Investment Management portfolio manager and vice president Shauna Sexsmith. "It was a powerful move and I can understand why people weren't happy. But I don't ascribe to the 'always hedge' school because the reason you buy foreign equities and global funds is to diversify outside of Canada, and the whole purpose of diversifying is to mitigate against the volatilities in your own market."
There is also a cost associated with a hedge position, she says. "My philosophy is that hedging is a tactical decision - when you buy a stock in another country, you're also making a call on the currency in that country. It goes up when the fundamentals are good and it goes down when the fundamentals are bad. If I'm overweight stocks in countries that have weak currencies, I may hedge out some of that excess currency risk."
Hedging reduces the risk of a further rise in the Canadian dollar, so an important question for Canadian investors is, "Where will our dollar go next?"
Dan Janis, senior vice president and portfolio manager, MFC Global in Boston, Massachusetts, says, "Over the past five and a half years, we've had a dramatic fall in the U.S. dollar, caused by factors such as the budget deficit, the current account deficit, a weaker economy and outward flow (of currency) from the U.S. into foreign markets. For example, the euro was launched in 1999 at $1.17, went as low as $0.82 and is now $1.53."
The question today, says Mr. Janis, is "Where did we come from, where are we at, and are we going to move significantly more? I think it's very difficult (for non-U.S. currencies) to go dramatically higher from here."
The Canadian dollar's relative strength must also be viewed in historical context, he says. "When we bought
Canadian currency more than five years ago, I was looked on as crazy - the Canadian dollar had weakened from 1991 to 2001, for 10 years, so people didn't know anything but weakness. They missed the fundamentals that were changing: positive current account, surplus budgets, the Quebec separation issue being put to rest, commodity prices, and a government where both sides were committed to budget surpluses."
Today the situation is less promising. "The commodity story is still there, but we've had a lot of mergers and acquisitions in Canada in the last five years and it's unlikely to continue at the same pace. We have the first current account deficit since 1999. The currency already reflects the good fundamentals, so I don't see much upside. I think it could weaken by 10 per cent to 15 per cent, which might be better for Canada's adjustment
to a stronger currency," he says.
The spillover from the U.S. economic slowdown is beginning to affect other countries, says Mr. Janis, creating further downward pressure on other currencies. "Some of the trade numbers in Europe are lower, the UK has experienced its own meltdown in real estate, Canada has cut rates and its economy is slowing down. Currency movements have been pretty extreme, but I don't see them being as extreme going forward."
Just as the Canadian dollar was viewed most negatively just prior to the beginning of a rapid ascent, it may be that expectations for the U.S. are mired in the past. "We have to caution this massive negativity, at this point in time, because we've come a long way."
Next page
Return to main page