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That Sinking Feeling

Sagging Canadian dollar got you down? Here's how to protect your portfolio against currency swings

The Canadian dollar often makes no sense. Year after year, it seems ripe for a rally, then it slips into the old pattern of declining a little further or climbing a small amount. The dollar hit a modern-day peak of $1.0443 (U.S.) in April, 1974. When the Parti Québécois was first elected in 1976, it was still trading near $1 (U.S.). Then came the long, bumpy decline.

Forecasting the level of the dollar is a game that has humbled economists and academics. The best advice for individual investors: Don't try this at home. But the currency can have a big impact on your portfolio. Whether you want to move holdings out of the Canadian dollar, or minimize fluctuations, you need a strategy for what I'll call dollar-smart investing.

If your investments are already diversified on a global basis, you're already much of the way there. Say you own a U.S. equity fund denominated in Canadian dollars and the Canadian dollar declines against the U.S. dollar. Your investment gets a lift even if the U.S.-dollar prices of stocks in the fund remain flat.

If you hold a global equity fund, then you'll likely have exposure to several currencies, some gaining and some losing against the Canadian dollar. A big move by the dollar relative to one currency probably won't push your portfolio off track. Global diversification also boosts your potential returns from the investments themselves, and spreads risk among more countries and industries.

For most investors, that global diversification will be enough. But you can diversify even more by buying funds denominated in U.S. dollars or funds that use hedging to protect against currency swings. More about both those strategies later.

There's no foreign-content limit for non-retirement accounts, but for registered retirement savings plans, the limit is 30% of the book value of your RRSP portfolio, which means the purchase price plus distributions. Unfortunately, few Canadians have anywhere near that much foreign content in their RRSPs. A poll published earlier this year by Royal Bank found that the average was just 9.9%. Also, 35% of respondents had no foreign content. In fact, you can effectively invest 100% of your retirement savings abroad thanks to a wide variety of derivative-based foreign mutual funds and foreign exchange-traded funds (ETFs) that are considered domestic content for RRSPs.

Ted Cadsby, president and CEO of CIBC Securities and author of the book The 10 Biggest Investment Mistakes Canadians Make, says that one of the biggest errors is focusing too much on Canada. He suggests an asset mix with 25% of your equity holdings in Canada, 45% in the United States and 30% in international stocks. "The question isn't why so little in Canada," he says. "The question is, if this country represents about 2% of global markets, then why so much in Canada?" Cadsby also recommends keeping 25% of your bond holdings in foreign bond funds.

When selecting foreign content, you often have the option of buying securities denominated in either Canadian or U.S. dollars. Just about every mutual fund company in Canada offers at least a few U.S.-dollar versions of its U.S. and international funds. The Mackenzie fund family, for example, offers almost 40.

You can also buy U.S. stocks, bonds and ETFs on U.S. exchanges. Popular ETFs include so-called Cubes, which track the Nasdaq 100 Index, and Spyders, which track the Standard & Poor's 500. Also, many foreign companies, such as Deutsche Telekom AG and Volvo AB, have their shares listed on U.S. exchanges as American Depositary Receipts. If you're even more adventurous, you can buy European, Asian or other foreign stocks on their home stock exchanges, but only with the help of a broker.

Should you buy in Canadian dollars or U.S. dollars? If you buy Canadian-dollar funds with foreign holdings, the fund managers will get a far better exchange rate than you would if you buy through your broker. On the other hand, buying securities denominated in U.S. dollars can work well if you already have money in a U.S.-dollar bank account, or if you think you'll need U.S. dollars when you cash in your investments.

Buying in U.S. dollars also insulates you from the interplay of the Canadian and U.S. currencies. If you buy U.S. stocks or funds in U.S. dollars, you'll get the same returns as U.S. investors.

Results of the Templeton Growth Fund, a global equity fund, show how this can happen. Thanks to the sagging Canadian dollar, the Canadian-dollar version of the fund posted an average annual return of 10.2% for the 15 years ended Jan. 31. The U.S.-dollar version, which reflected just the gains in the stocks themselves, earned an average of 8.8%. Obviously, the reverse would happen if the Canadian dollar rises.

If you want extra protection against dollar uncertainty, consider a small investment in a global mutual fund that hedges against currency fluctuation by using derivatives. Take the global funds in the Cundill family owned by Mackenzie Financial Corp. They use hedging to smooth out currency moves, producing results that, in theory at least, are based only on the fund manager's stock-picking ability. The Mackenzie Cundill Value Fund (the widely available C version) had a three-year return to Jan. 2, 2002, of 19.2%, while the average global equity fund was down 3%.

Dan Hallett, a mutual fund analyst with Sterling Mutuals Inc. in Windsor, Ont., says the foreign index funds offered by Royal Mutual Funds Inc., TD Asset Management Inc. and Altamira Investment Services Inc. also use hedging. The Talvest fund family is particularly active in managing currency risk.

However, most foreign equity funds don't use hedging, according to Morningstar Canada's director of research, Stephen Burnie. His company surveyed European equity funds to check on the amount of reported hedging. "We found it was very low, and that managers were not very forthcoming with information."

Don Reed, president and CEO of Franklin Templeton Investments Corp. and lead manager of the $5.3-billion Templeton International Stock Fund, says his firm doesn't use hedging because many companies in its holdings do their own hedging. It is also costly. Reed said Templeton once assessed how perfectly executed hedging would have affected a portfolio over 10 years. "The return would have increased by 25 basis points," he says (a basis point is 1/100th of a percentage point), "but the cost of the hedge would have been 125 basis points."

Constructing a portfolio by making big currency bets is a bad idea, but you can make a small wager and enhance diversification. The Canadian dollar has hung in against the euro lately. But Reed and other experts see the euro rising this year as economies rebound and tax cuts take effect. If you buy a European equity fund, or an international fund with a big weighting in Europe, like Templeton International Stock, then you would benefit if European stock markets rise and the euro climbs against the Canadian dollar.

Ranga Chand, an economist and author of the annual Chand's Top 50 Mutual Funds, says the U.S. dollar is overvalued, and he sees major currency shifts in the years ahead. Still, he says portfolio diversification is the way to reduce currency risk, not specific investments to profit from the dollar rising or falling. Picking the right stocks is hard enough. Getting currency moves right as well is a tall order, even for the pros.

Like many foreign-content mutual funds, the Templeton Growth Fund is available in versions denominated in Canadian or U.S. dollars. As the bar chart shows, the Canadian-dollar version has posted higher returns over the last 15 years. Those returns derive from two sources: a rise in U.S. and other foreign stock prices, and a higher U.S. dollar when those prices are converted to Canadian dollars. The returns on the U.S.-dollar version reflect only the higher stock prices, so they are a clearer indication of the manager's stock-picking ability. Also, U.S.-dollar investors do not have to accept the prevailing exchange rate when they sell their holdings - they can convert their currency at a later date.

Average annual return, 15 years*

Cdn.-dollar version     10.2%

U.S.-dollar version      8.8%

-*To Jan. 31, 2002

© 2007 The Globe and Mail. All rights reserved.

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