When investors buy shares in a foreign company or mutual fund, they make two investment decisions. They’re betting on the performance of the company itself, as well as the currency in which the investment’s denominated, says George Davis, chief technical analyst for RBC Capital Markets.
“If you’re investing in the U.S. market, for example, you would have to sell Canadian dollars and purchase U.S. dollars to buy whatever investment you’re purchasing,” he says. “And your return would be influenced by the performance of the [U.S.] currency.”
In the mid-2000s, when the Canadian dollar drastically appreciated against the U.S. dollar, “A lot of Canadian fund managers and investors had investments in the U.S. equity market,” he says.
“The market did quite well and the returns were quite high. But if the investments were unhedged, the appreciation in the Canadian dollar basically wiped out all of the gains.”
The first decision investment managers face, says Davis, is whether to hedge against currency swings. “Some people want to take on that risk,” he says.
Craig Basinger, chief investment manager at Macquarie Wealth Management, is one. He manages a Canadian dollar fund, a U.S. dollar fund and a mixed Canada/U.S. fund, and strongly believes the U.S. dollar is on the upswing. So he’s chosen not to hedge his funds’ exposure to the greenback.
By investing directly in U.S. companies, his portfolios get double boosts from that country’s ongoing recovery—both through rising stock prices and a rising currency.
Those who want exposure to that recovery without taking on any currency risk can invest in Canadian companies operating in the U.S. “We’re focused a little bit harder on the North American cyclicals, industrial and technology companies, because those groups typically have more business south of the border,” he says.
Insuring against currency swings
Other investment managers hedge the risk of currency fluctuations on overseas holdings. That’s a wise tack for investors who aren’t well-versed in those currencies, says Davis, as well as for those with lower risk tolerance or high proportions of foreign holdings.
That’s why many mutual fund companies offer funds that are already hedged. “They allow you to participate in a foreign stock market without having to worry about the currency risk,” says Davis.
Examples include the iShares S&P 500 ETF hedged to Canadian dollars (XSP) and the Claymore Broad Emerging Markets ETF (CWO). Purchasing funds that already hedge can mitigate risk, he says. “The big fund companies handle many millions of dollars, so they’re able to get [cheaper] wholesale rates on the hedges,” says Davis. They also have staff dedicated to managing currency exposure.
The strategies
The main tools for guarding against currency risk are forwards and options, says Davis.
Forwards are agreements to buy or sell a currency at a specified rate on a certain date.
“You are obligated to meet the terms of that contract,” he says. “So, if you’re holding U.S. investments and you think the U.S. dollar is going to go down relative to the Canadian dollar over your holding period, you’d execute a contract that allows you to sell the U.S. dollar on a forward basis in order to help protect you from that expected decline.”
Options, on the other hand, give you the right, but not the obligation, to buy or sell your currency at an agreed-upon price on a specified date, says Davis.
You’ll pay a premium for that flexibility, but it may be worth the cost, particularly if you’re uncertain the U.S. dollar will move aggressively lower.
Premiums will differ according to the currency, transaction size, option duration, intrinsic value of the option, volatility levels and interest rate differentials.
Investment managers may also use the collar strategy. Let’s assume that you have long exposure to the euro, and it’s trading at US$1.34 on June 19, 2013. You anticipate the euro’s value will fall.
You purchase a 3-month put option, giving you the right to sell the euro at US$1.31 for a premium of 116 US points per euro notional amount; then sell a 3-month call option allowing the purchaser to buy the euro at $1.37 for a premium of 95 US points per Euro notional amount.
“You’ll pay a premium of 116 US points for the put option that you purchased, but you’re going to receive a premium of 95 US points for the call option that you sell,” says Davis. “So you can use the proceeds of the call to partially offset the cost of the put.”
If the euro is trading at $1.28 at the end of the 3-month period, then you would exercise your put option to make up for the difference between the strike price of $1.31 and the current market value of $1.28.
Conversely, if the euro is at $1.40 at the end of the agreed-upon time, the person you sold the call to would exercise the option, and you would sell your euros to them at $1.37.
If the spot rate is between $1.31 and $1.37, no options would be exercised.
You’ve defined a comfort range for the euro exchange rate between $1.31 and $1.37, says Davis. If the currency is worth far less you won’t be hurt, but if it’s worth far more, you won’t benefit either.
Other managers take active approaches to currency overlay programs, tweaking their hedges to try to juice returns, while others take passive approaches focused on eliminating extreme currency fluctuations.
But protecting against currency fluctuations adds an extra level of cost—an amount that will vary depending on the product used, transaction size, time period, levels of interest rates and market volatility.
Loonie predictions
In the short term, says George Davis of RBC, “we’re looking for the Canadian dollar to trade down to the 95-cent level into the end of the third quarter of 2013.” (It was trading at 98 cents at the time of the interview).
“I think short-to-medium term there are still some risks out there that argue for a little bit more Canadian dollar weakness,” Davis says. The contributing factors: a weaker growth profile than expected in Canada, and the fact that the Bank of Canada has had to tone down its hawkish rhetoric. Craig Basinger, chief investment officer for Macquarie Private Wealth, agrees. The Canadian dollar is “still viewed as a commodity currency,” he contends. “Our view is that the commodity secular bull [market] ended 18 months to two years ago. We continue to believe that and it’s not terribly supportive for the Canadian dollar.”
What’s more, Basinger believes the U.S. dollar is likely to build strength as the recovery continues. “Longer term, we’re going to see better economic data out of the U.S. and we’ll see the feds begin to draw back their quantitative easing. That should be positive for the U.S. dollar.”
Not everyone has faith in the greenback, though. Axel Merk, whose Merk Funds specialize in currency, takes the contrarian point of view. “Everybody seems to think that there’s good economic data associated with a strong U.S. dollar and a weaker Canadian dollar,” he says. “I don’t buy it.”
The biggest threat facing the U.S. in Merk’s eyes is strong growth. “That puts the bond market seriously at risk and with that, the deficit might not be sustainable,” he says. So the Canadian dollar should be a lot stronger than it is right now. “Having said that,” he adds, “the Canadian dollar has been difficult to predict.”
Currency hot spots
Axel Merk, president and chief investment officer of Palo Alto, Calif.-based Merk Funds, has made a career out of predicting fluctuations in the currency market. But these days, he says, “investors may want to take a diversified approach even to something as mundane as cash.” The big challenge: “There isn’t a single safe place.” The currencies he favours include:
The Eurozone is the one region “where they’re mopping up liquidity,” says Merk. “The central bank balance is shrinking.” And yet, he says, the euro “is about as hated as it can be.” The upshot: it offers good value.
The New Zealand dollar: Merk prefers it over the Australian dollar even though it’s “not cheap.” The
key factor: its exposure to soft agricultural commodities.
The Canadian dollar: Policy-makers have been less involved in the market in Canada, says Merk, so prices are more apt to reflect fundamentals.
The Korean won, the Malaysian ringgit and the Taiwanese dollar: “The negative fall-out from the Japanese policies on the rest of Asia might be a bit over-rated,” he says. “Japan has a huge problem, but it’s mostly a Japanese problem. These countries might actually benefit from the situation.”
Camilla Cornell is a Toronto-based financial writer.