Protecting your portfolio against currency changes

In our conversations with clients, one question keeps coming up these days:
“The Canadian dollar has dropped a lot. How is this impacting my investments?”

You may have wondered this yourself so we thought to address it here. To clarify, when the Canadian dollar falls, as it has by 7% against the U.S. dollar in 2015, the value of U.S. holdings in a portfolio rises. The reverse is also true. For example, from 2002 to 2007, when the Canadian dollar climbed from about $0.63 to over $1.02, the S&P 500 returned over 6% annually in U.S. dollars, but lost about 2% a year in Canadian-dollar terms. Many investors have seen otherwise solid returns wiped out by currency fluctuations.

Predicting currency patterns is one of the most challenging tasks in the field of investing. Today, more than ever. And while we are the first to remind clients that we are not currency traders, you can’t ignore exchange rates when investing internationally. There are two ways to look at the issue:  first as owners of U.S. assets and second as potential buyers.

Those who have been following our strategy know that since 2010 we’ve been putting a lot of money to work in the U.S., predominantly in the stock market and private real estate (e.g. apartment buildings). For much of this time, the Canadian dollar was close to par and the beat-up U.S. market was giving us an opportunity to buy quality assets at reduced prices. This strategy played out nicely given both the loonie’s decline and the uptick in the U.S. economy over the past four years.

The challenge before us now is to protect these gains should the Canadian dollar recover. Because while it may fall further in the short-term, it is unlikely to stay at current levels over the medium to long term.

The second issue is with respect to potential new investments in the U.S. In front of our investment committee currently are several U.S.-based real estate investments that look attractive. Yet, if we are buying U.S. assets with 80 cent dollars and the dollar rebounds to, say, 90 cents, we need to be comfortable that our target return is still attractive. This is a regular point of analysis and discussion at our investment committee meetings.

There are a number of factors that impact exchange rates and we believe it is best for us to avoid predictions. From our perspective, the answer is to put a hedge on a portion of our U.S. dollar-denominated holdings. (To hedge is to enter into a financial contract to protect against unexpected, expected or anticipated changes in exchange rates.) We recently hedged one third of our U.S. exposure and will continue to manage this risk going forward to protect client returns and capital.

Currency hedging is not a panacea – there is a cost, it is imprecise and it only protects the value within a certain range and for a certain period of time under the contract. And there’s the possibility the Canadian dollar could go lower still. (The pundits’ forecasts range from 70 to 90 cents over the next year.) However, in this volatile, low-interest rate investment climate, where every percentage of return is hard won, we think it makes sense to lock in some of our gains. It’s all part of our approach to protecting capital first — especially when we can buy that protection at a cost that is reasonable – and above all, to be prudently diversified.