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Canadians seem to be very aware of the currency exchange rate with our southern neighbours. For some of us, the status of the U.S. dollar impacts our lifestyle, travel plans, livelihoods as well as our investments. Currency movements can present an element of uncertainty for Canadian investors but they can also be a benefit.
The loonie declined by 16% relative to the U.S. dollar in 2015, a move that was largely celebrated by Canadian exporters and tourism operators because it made our goods and services more affordable to Americans. But for Canadians whose businesses rely on U.S. imports, the loonie drop made for a hard time, passing along extra costs to Canadian customers.
For Canadian investors, the flagging loonie was a boon for those whose portfolios include (unhedged) U.S. and global holdings.
Exhibit 1 shows various index returns in local currency terms and returns expressed in Canadian dollar terms. The U.S. market was up modestly at 1.4% for 2015 in local currency terms, while it recorded a return of 21.6% in Canadian dollar terms. The returns in Canadian dollar terms not only account for changes in the prices of the securities, but also for gains or losses versus the Canadian dollar. As you can see, all of the foreign investments had far more impressive gains in Canadian dollar terms.
How exchange rates affect foreign mutual fund returns
The impact of exchange rate movements (also known as currency risk or exchange rate risk) applies when investors purchase mutual funds that hold foreign securities, such as U.S. stocks. Canadian investors typically purchase U.S. mutual funds using Canadian dollars, but in order to buy U.S. stocks and bonds, fund managers first have to convert this money to U.S. dollars.
Change in value of securities + Change in exchange rate
= Total return of foreign mutual fund
It’s important to note that most mutual fund unit prices and their rates of return are reported in Canadian dollars, even if it is a foreign fund. Because mutual funds are valued in Canadian dollars, with all things being equal, when the Canadian dollar rises, the value of a U.S. investment falls (in Canadian dollar terms). Conversely, if the Canadian dollar declines, the value of a U.S. investment rises.
Exchange rates vary over time
While in most cases a falling Canadian dollar has helped Canadian investors holding most U.S. equity and fixed income investments since 2012, the opposite effect occurred from 2009–2011 when the Canadian dollar was strengthening. Exhibit 2 shows a significant period in the mid-2000s (see 2003–2007 on the chart), where this was the case. Those with long memories will recall that this was a period in which Canadian equity funds generally held their own versus U.S. equity funds and even outperformed in many cases.
Exchange rates have less impact over the long term
While exchange rates can have a significant impact on investment returns in the short term, the impact lessens over the longer term (Exhibit 3). In fact, over periods of 15 years or longer, the impact of exchanges between the Canadian dollar and the U.S. dollar on investment returns gets closer and closer to zero – an important point for long-term investors.
Currency hedging basics
Mitigating the impact of exchange rates
Although the effect of currency fluctuations diminishes over time, there are ways to mitigate the impact of exchange rates in the short term. Portfolio managers use investment tools to hedge currency in an attempt to mitigate the impact of currency. Regardless of how much the Canadian dollar moves after hedging, investors know that there will be limited impact on investment performance due to currency movements.
Currency hedging and your mutual funds
A mutual fund may hedge all of its foreign currency exposure, and funds that do so are called “currency hedged” or “currency neutral” – e.g., RBC International Equity Currency Neutral Fund. This is called “passive” hedging, as the portfolio is always 100% currency hedged. Or, a fund may provide “active” or “tactical” currency management, in which currency exposures are determined by a team of currency specialists with the goal of managing risks and adding value.
Currency hedging has drawbacks as well
The primary drawback of hedging is that if the Canadian dollar falls relative to a foreign currency, the opportunity for higher returns based on exchange rate movement is lost. The upside is that the investment is protected against a rise in the value of the Canadian dollar relative to foreign currencies. Similar to an insurance policy, the objective of hedging is to remove uncertainty. But just like there’s a cost to purchase an insurance policy, there’s typically a cost to enter into a hedging agreement. Fortunately, the cost is minimal with solutions like mutual funds given their large size and professional management.
Key currency principles
Investors shouldn’t make investment decisions based on expectations of future foreign currency movements. Here are a few reasons why:
1. The impact of currency movements tends to diminish over time
While exchange rates fluctuate from year to year, the impact of currency on investment returns declines over time. As highlighted previously, over longer time periods, currency movements have little impact on performance.
2. In a diversified portfolio, currency movements tend to even out
A well-diversified portfolio has exposure to many different currencies. For example, global mutual funds will typically hold securities from the U.S., Europe and Asia – all denominated in different currencies (e.g. U.S. dollar, euro and yen). Often a rise in one currency is offset by a decline in another. The interplay between baskets of currencies is sometimes referred to as a natural hedge.
3. Rebalancing provides currency valuation discipline
For investors whose diversified (and unhedged) portfolios have seen substantial gains in foreign mutual funds due to currency movements, the discipline of portfolio rebalancing may provide a form of currency management. For example, if your Canadian holdings have had minor declines over a year, while your unhedged foreign holdings have gained 20%, you may have to rebalance to get your allocations back to your target mix.
4. There’s little reward for betting on currency over the long term
Currencies can fluctuate more in value than the stock market. Over time, investors are simply not rewarded for currency fluctuations the same way they are rewarded in the stock market. The long-term trend for the stock markets is up; the relative gains and losses of currencies provide no such added value over the long term.
We offer a number of currency-hedged or currency-neutral fund options
PH&N Investment Services offers mutual funds with different currency management approaches. If you’re interested in learning more about managing your portfolio’s currency exposure, please speak with one of our Investment Funds Advisors at 1-800-661-6141. They can help you construct your portfolio according to your preference and comfort level.