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Dale Jackson

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Avoid a currency trap

Dale Jackson

TORONTO (GlobeinvestorGOLD) — Telling investors about the danger of getting into U.S. equity funds without a currency hedge is like closing the barn door after the horse is gone. Since January 2002, the loonie has soared from 61.75 cents against the U.S. dollar to around 90 cents today — knocking roughly 30 per cent off of each Canadian dollar invested in U.S. denominated funds way back then.

We live and we learn — and just in the nick of time. Back in 2002 RRSP investors were constrained by a 30 per cent foreign content limit. At that time foreign investing often meant U.S. investing. Now that the foreign content limit is lifted we're free to roam the globe looking for the best opportunities and that's why it's crucial to look at the big currency picture.

First, investors should never make currency considerations the main reason for choosing an investment. When it comes to choosing the right global equity fund the primary factors should be return potential, risk, and suitability to the individual investor's portfolio. For the average retail investor, and in many cases even for the experts, predicting currency changes is little more than an educated guess.

If currency investing is what you want there are a few hedge funds that attempt to capitalize on currency changes but they can be risky. Global or international equity funds could provide a built-in currency hedge if they are well diversified along geographic lines. For geographically specific funds there are a few hedging tricks equity fund managers can initiate to temper currency risk but they can backfire. In the end it's up to individual investors to take precautions to limit currency risk within their own portfolios.

The best way to avoid getting caught in a currency trap is to diversify beyond Canadian and U.S. dollar equity funds. Over the past three months the Canadian dollar has risen 3.9 per cent against the U.S. dollar. That means even if your U.S. dollar investment was flat, your total investment has devalued by nearly 4 per cent. But during the same three months the Canadian dollar has depreciated 3.4 per cent against the Japanese Yen and 3.9 per cent against the Euro. Even if a Japanese or European denominated equity fund was flat the investor would still be up over 3 per cent in both cases. Since it's almost impossible to predict where currencies are headed wise investors would strive to have a mix of U.S., Japanese and European denominated equity funds in their portfolios.

Several mutual funds are available on the market that can provide a diversified currency portfolio — if properly mixed. The Globefund filter includes a list of asset classes based on sector or geography, or both. Funds are available in many currencies but the must-have denominations are U.S., Japanese and European because they are the most stable and widely used. The British Pound Sterling is also a currency to consider but has been losing influence as the Euro has grown in stature.

It's also important for Canadian investors to have Canadian currency funds if that is the currency in which they will be doing most of their spending. Snowbirds should consider a heavier weighting in U.S. denominated funds so there will be less risk of volatility when it comes time to cash-in and spend in the United States. Several mutual funds have U.S. denominated twins for just that reason.

Big global investment banks put a great deal of time and money researching how their investments will be impacted by currency fluctuations going forward. CIBC World Market puts out a weekly foreign exchange outlook that takes into account variables such as economic activity, inflation and interest rates.

The most recent report forecasts the U.S. dollar to strengthen against the Canadian dollar from $1.09 in the second quarter of 2006 to $1.20 in the fourth quarter of 2007. During the same period CIBC World Markets expects the Euro and the Yen to strengthen slightly against the U.S. dollar. If the forecast is correct, Canadian investments in U.S., Japanese and European equities could get an extra boost. Why not have a mix of each just to be safe?

Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.

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