Currency hedging: Keep your portfolio from tumbling as the loonie climbs

It's up, it's down, it's up again — how to hedge your investments in the face of rapid currency fluctuations.

When the Canadian dollar reached parity with the greenback in September 2007, U.S. border crossings were jammed. Deal-seeking Canadians braved four-hour waits just to get 20 bucks off a pair of Banana Republic khakis — and who could blame them? The last time the currencies were equal was in 1976. But, while giddy consumers ransacked U.S. malls, many Canadian investors watched in horror as their portfolio values plummeted.

Rapid currency fluctuations like we’ve seen in the past couple of years can be a nightmare, especially if an investor has a lot of cash tied up in American funds. On Nov. 7, 2007, the loonie reached a modern-day high of US$1.10. Since then, it’s been up and down; this year, it bounced between US$0.76 and US$0.97 and, with the U.S. dollar continuing to weaken, it doesn’t look like our currency headaches will disappear any time soon.

To get some idea of how much Canadian money is tied up in the U.S. market, consider that in the first 10 months of 2009, Canadians owned $31 billion in U.S. mutual funds alone, according to financial consulting firm Investor Economics. As the loonie inches closer to par, the worth of all of these investments continues to slide. Stephen Lingard, co-lead manager of Franklin Templeton’s Quotential Program, says that typically, when people invest in a foreign market, they get a “local return” — i.e., if the fund is up 10%, then you’re up 10% — as well as a currency return. “You have a local return of 10%, but if the Canadian dollar strengthens by 5%, the actual return of that investment is only 5%,” he explains. (On the upside, if the loonie weakens, investors will make more.)

Usually, currency changes aren’t dramatic enough to do any significant damage. Between 1991 and 2002, the Canadian dollar steadily declined, but since then, as the loonie has shot up, many Canadian investors have found themselves in the position of rooting against the home team.

Fortunately, there are ways to mitigate the negative effects of currency fluctuations. The most popular method is through hedging, or offsetting financial risk, using one of several techniques. For instance, investors can opt to buy currency exchange-traded funds. An ETF tracks an index — in this case a foreign exchange market. An investor may sink some cash into a euro ETF so that when the U.S. dollar drops, the ETF’s value will rise, offsetting any portfolio losses in the process. It’s also possible to buy a European-based mutual fund in Canadian dollars. “If the euro rises,” says Robert Gorman, chief portfolio strategist at TD Waterhouse, “that will be reflected in the share price of the European companies,” and the fund’s worth will increase.

Investors also have the option of opening a bank account in another currency and just parking cash there. In the future, if the Canadian dollar rises above parity, that person can purchase cheap U.S. dollars, leave the money in the account, and then cash out when the loonie falls again.

Mutual fund companies often hedge by purchasing futures contracts, which involves trading one currency for another (in this case, the U.S. for Canadian dollars) at a future date and at a fixed price. This technique locks in an exchange rate, so the fund isn’t affected by currency movements. “There will always be a price for someone to take U.S. dollars off your hands,” says Lingard. This method comes with a fee, he says, though it’s a relatively small one.

There are other ways to hedge — buying gold is a good one, since its value always rises when the U.S. dollar decreases. And stocking up on U.S. funds when the Canadian dollar is above parity will make you money as the loonie decreases.

Some investors choose simply to invest only in Canadian funds. Gorman says that’s a particularly good option for retirees who shouldn’t have overly volatile portfolios. (If low-risk investors want to invest in American stocks, they can look at multinational corporations who get most of their earnings from foreign markets. If the U.S. dollar drops, the company’s overseas earnings will increase and that should stabilize share prices.)

Perhaps the best way to avoid a currency crisis is to do nothing at all. Gregg Wolper, editorial director of mutual fund content at Morningstar, admits that while dollar changes can impact a portfolio over the long term, it’s too difficult to predict what that effect will be. “Even the experts get crossed,” he says, adding that worrying about proper asset allocation and diversification is more important than stressing over currency movements. However, if you really want to take advantage of dollar changes, there’s one foolproof way to come out on top: visit the nearest American mall.