When it comes to travelling south of the border, the value of our loonie is top-of-mind. If the Canadian dollar dips below 70 U.S. cents, we tend to feel that going south is just too pricey. Conversely, when our loonie soars to above parity with the U.S. dollar (most recently 6 years ago), we rush to shop and travel across the border.
How do currency changes affect us?
First, let’s look at why the value of the Canadian dollar affects our investment portfolios: Since Canada has a small and not very diversified stock market, we tend to invest much of our stock portfolios in the U.S and elsewhere, via mutual funds, exchange-traded funds, or individual stock purchases. Ideally, investors should build a diversified portfolio to manage risk. Holding a variety of assets, in a variety of global markets, and in a variety of global currencies, allows us to benefit when any of these markets or currencies performs well.
How you respond to loonie fluctuations depends on whether you follow an active or passive strategy.
Passive investors: Take a Pass
Passive investing involves buying and holding diversified index funds. It does not involve short-term trading to profit from market conditions. Passive investors should not alter course because of fluctuations in the value of the Canadian dollar. Over the long term, it’s impossible to predict these currency changes… even though economists keep trying.
Active investors: Consider Your Choices
If you’re an active investor, fluctuations in the Canada-U.S. exchange rate may entice you to either buy or sell stocks or currencies. Some active investors will shift assets from Canadian-dollar accounts into U.S.-dollar accounts when the Canadian dollar appreciates relative to the U.S. dollar, and will do the opposite when the Canadian dollar drops in value. A low value of the Canadian dollar may provide an attractive opportunity to sell a U.S asset and convert the funds into Canadian dollars, and vice versa.
What is Hedging: It’s a bet on the Loonie
Canadian investors have the option of purchasing hedged international index funds that use derivatives to offset the effect of changes in the value of the Canadian dollar on the funds. That means that the change in the value of these funds in Canadian dollars reflects only the changes in the value of the underlying assets – not the extra change in the Canadian dollar relative to the foreign currency.
Here’s an example: Let’s say I hold an unhedged S&P 500 index fund denominated in Canadian dollars that trades on the Toronto Stock Exchange. If the S&P 500 goes up by 10% and the Canadian dollar goes down by 5%, my fund goes up by about 15%. When the Canadian dollar falls, the unhedged Canadian investor benefits. (Yeah!) If I hold a hedged U.S. S&P 500 index fund that is denominated in Canadian dollars, the value of my fund goes up by about 10%, since it’s insulated from the impact of the change in the Canada-U.S. exchange rate.
Now, let’s say the U.S. index goes up by 10% but the value of the Canadian dollar goes up by 5%. In this case, the unhedged investor loses out, making a gain of only 5%, while the hedged investor makes a gain of about 10%. When the Canadian dollar rises, the hedged investor does better than the unhedged investor.
We can see from these examples that hedging gives the Canadian investor protection from a rise in the value of the Canadian dollar but offers no benefit from a drop in the value of the Canadian dollar. An investor expecting the Canadian dollar to drop in value should not hedge, whereas an investor expecting the Canadian dollar to rise should hedge.
As with all investment decisions, whether to hedge or not to hedge depends on your appetite for risk and your level of confidence in your predictions. As an economist, I can attest to how hard it is to predict exchange-rate movements. What I tell my students when asked about hedging is that unless you have a very strong reason to expect the Canadian dollar to rise significantly from current levels, don’t buy hedged funds. A second reason not to hedge is that the process of hedging involves higher fund expenses, so hedging will translate into slightly lower returns after fees in the long term.
However, if you’re planning a holiday in the U.S., buy U.S. dollars when the Canadian dollar appreciates the exchange rate is more in your favour. When will that be? Don’t ask me, I’m just an economist!