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Updated: Tue, 22 Apr 2014 08:00:00 GMT | By Mark Brown

How to protect your investments when the dollar is on the move

The loonie's value has fallen. It may be time to cut your currency risk


George Washington and Queen Elizabeth facing off on currency

After a relentlessly frigid winter, the only thing many Canadians can think about is how soon they can flee the country for an early taste of summer. Sadly, recent polls suggest the recent dip in the dollar will derail many of those travel plans.

When it comes to the exchange rate's potentially much greater impact on their portfolios, however, investors tend to bury their heads in the snow. "One of the most important points to make to investors who are investing outside of Canada is that they are really taking on two investments: one is whatever they are investing in, but they are also taking on the currency risk," notes Camilla Sutton, Scotiabank's chief currency strategist. If you're 100% unhedged, then you are implicitly making a bet on currency.

Consider what's happening in Japan. In the dying months of 2013 the yen fell 8% against the U.S. dollar while the MSCI Japan index climbed 8%. Counted in greenbacks, in other words, it was a wash, unless you held something like the db X-trackers MSCI Japan Hedged ETF (NYSE: DBJP), which muffled the effects of the currency drop.

The situation was reversed for Canadians investing in the U.S. markets. During the first few months of the year the S&P 500 rose by less than 2%, but Canadians who invested in the index are up more than 5%, thanks to the loonie's fall to 90¢ (U.S.). Great news for them-but our buck could swing back the other way just as quickly.

Martin Kremenstein, head of U.S. exchange-traded funds for Deutsche Bank, says there are several ways to look at currency hedging. One approach is to regard it from a purely tactical perspective, where the investor takes a position on a single country. The aggressive economic reforms being put in place by Japan's president Shinzo Abe are a perfect example. A bet against the yen was a smart move in this light. Investors recognized that Abenomics was going to devalue the yen and thought that would be good for Japanese equities, explains Kremenstein.

Another approach is to use hedging to limit the swings in your portfolio. "When you hedge out currency exposure you actually reduce volatility by 20% to 25%. It can be a way to execute a low-volatility strategy without having to optimize the equity position," he says. "You are managing your volatility through the elimination of a risk factor, in this case currencies."

Of course, if you're going to hedge, it helps to have a view on what exchange rates are going to do. That can be tough, and some advisers argue that you shouldn't try. Justin Bender, a portfolio manager at PWL Capital Inc., favours passive portfolios with long time horizons. He doesn't see the benefit of hedging unless you're trying to time the currency markets. "For long-term investors I don't think hedged ETFs are necessary," he says. Besides, he adds, multiple currencies help diversify a portfolio.

Kremenstein doesn't buy that argument. "I think that's been a convenient way for people to justify the fact that they don't have any control over currency fluctuations," he says. "One of the excuses for not hedging is to say currencies are a diversifier, but saying currencies are a diversifier means you like a currency at any price." There is a big difference between the yen at 72 to the U.S. dollar and the yen at 120, he goes on; it's the same as saying you like Apple at $400 just as much as you like it at $1,000.

For those unwilling to add currency research to their due diligence, however, there is a middle way. A 50-50 split between hedged and unhedged investments is a good start, says Kremenstein. If you hedge half of your foreign holdings back into Canadian dollars, you can reduce your risk without making a specific bet on which way a currency will go.

"The 50% hedge ratio is the path of least regret," echoes Sutton. It shouldn't come as a surprise then that this strategy is favoured by institutional investors. This is something Canadian investors should think about soon, too. By year-end, Sutton sees a Canadian dollar that is stronger against the euro and the yen and subject to more volatility against the U.S. dollar.

Some ETF providers such as Vanguard now offer hedged options for the same fees as their unhedged counterparts, although many hedged ETFs still add 10 basis points to the management expense ratio to cover the extra cost. Even then they aren't always perfect. Between March 2009 and November 2011 the Canadian dollar gained 29¢ (U.S.), touching US$1.06. If there ever was a time to hold a hedged ETF, this should have been it, says Bender. But some ETFs didn't behave the way investors expected. Over that period the S&P 500 returned 75%, but iShares S&P 500 Index Fund CAD Hedged (TSX: XSP) returned almost 10 percentage points less. Still, that beat the alternative: Canadians who bought the S&P 500 in U.S. dollars would have netted just 40% north of the border.

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