Justin G. Charbonneau, CFA, DMS, FCSI, VP, Portfolio Manager, Matco Financial Inc.
Stance: It only makes sense when downside risk is high
Now ain’t the time
There are two separate schools of thought on currency exposure. One school propounds diversification—some will fall, some will rise; the net result is neutral. The other promotes hedging.
We do non-traditional currency hedging through macroeconomic analysis and bottom-up security selection. It entails an overall risk management, asset allocation and investment selection strategy, which seeks the best risk-adjusted return (as opposed to using traditional currency hedging tools).
When building a global portfolio with currency risk layered on, you need to gauge where your currency historically stands, relative to present-day valuation versus foreign currencies.
If there’s a strong probability your currency will rise, you could invest locally to mitigate or avoid currency risk. If it’s poised to fall, you should look to invest in other currencies. Investors should also match up their foreign liability exposure with foreign-denominated assets so as to naturally hedge their portfolios.
In the last 10 years, if you were a Canadian investor making U.S. investments, you’ve seen the value of your investments drop because the American dollar depreciated roughly 30% to 40%, relative to Canadian currency.
With the loonie just under parity today, it doesn’t make sense to hedge in USD, given the downside risk is much lower compared to a historical maximum CAD $1.10 (that means the quantified downside risk is 10%). The upside of not hedging is 25%, assuming a CAD valued at $0.80 USD (which is the midpoint of the last decade).
We actually doubled our exposure to foreign assets—most of them U.S. dollars—six-to-nine months ago when the CAD/USD exchange rate was around $1.02 to $1.03.
We believed the risk of the Canadian dollar rising was much lower than the risk of it falling, given the correlation of Canada’s resource-based economy and how commodity prices affect inflation. If investors were to actively hedge now, they might lose out on a potential tailwind if the Canadian dollar depreciates.
Currently, our flagship balanced fund comprises about 20% foreign equities (2.5% European; 2.5% Asian; and 15% U.S.) and 35% Canadian. The rest of the fund is investment grade fixed income and cash equivalents.
When hedging makes sense
The underlying purpose of hedging is to mitigate the risk of an unfavourable, yet likely, outcome. The Canadian dollar back in the late 1990s was worth $0.65 US. Today, it’s just under parity.
The approximate 50% appreciation relative to the USD in valuation over the last 10 years meant hefty gains for global investors with assets denominated in Canadian dollars. Looking back, currency hedging to USD, from a Canadian investor’s perspective, made a lot of sense given the downside risk was high. Not now.
Currency hedging may be warranted in the case of bonds where the variation of returns is low and investors need to protect themselves from seeing their returns wiped out by potential FX losses.
Again, one has to look historically in terms of the relative valuations of one’s currency against foreign assets.
Currency exposure is dependent on the client’s risk/return objectives, and any future liabilities with respect to generating a portfolio return. For risk-averse clients with shorter time horizons, currency hedging may make sense.