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U.S. funds caught in a currency rut

Hedging key when Canadian dollar soars

Don't hold your breath waiting for that U.S. equity fund you bought a few years ago to make a big comeback. In most cases U.S. equities aren't the problem -- it's the weak U.S. dollar. And it doesn't look like the greenback is going to find its footing any time soon.

The average U.S. equity fund sold on the Canadian market has dropped in value by 8 per cent each year for the past five years, even though U.S. equities have advanced beyond the break-even point.

The U.S. stock market has been showing signs of improvement more recently but the widening currency difference is continuing to pull U.S. equity funds lower. Blindsided fund managers are likely kicking themselves for not hedging against currency fluctuations.

Since Jan. 21, 2002, the Canadian dollar has gone from 61.75 cents against the U.S. dollar to right around 90 cents today. That means a U.S. denominated fund bought in Canadian dollars at the loonie's low point would be down about 30 per cent even if U.S. markets had remained perfectly flat.

Two similar U.S. equity index funds provide a stark example of what happens when one currency is hedged and the other is unhedged. The TD U.S. RSP Index and CIBC U.S. Index RRSP funds both track the S&P 500 composite total return index. Both are throwbacks to the days when registered retirement savings plans were limited to 30-per-cent foreign content, so fund sponsors used derivatives to mimic the stocks and their relative weightings on the S&P 500 to get around the restrictions. They were known as clone funds. The whole setup is complicated but in purchasing the derivatives, fund administrators had the option to hedge, or partly hedge, against currency fluctuations.

The TD fund hedged enough to close the currency gap while the CIBC fund did not, and the difference between the two is in the returns.

The TD U.S. RSP Index fund mirrored the S&P 500 -- currency fluctuations and all. The difference in the corresponding lines on the accompanying chart is mostly the result of a small management expense ratio (MER) of 0.89 per cent charged to fund holders. After five years the fund has advanced by nearly 2 per cent annually.

The CIBC U.S. RRSP Index fund, on the other hand, mimicked the S&P 500 in U.S. dollars. Unfortunate investors who bought the fund in Canadian dollars got burned on the exchange rate. Factoring the exchange rate over the same five-year period and the CIBC fund lost nearly 5 per cent each year.

Like the CIBC fund, most managed U.S. equity funds did not hedge the currency and investors are feeling it in their portfolios. The best advice at this point according to Ian Filderman, director of mutual funds at Scotia Capital, is to not attempt to close the barn door after the horse is gone. "Hedging the currency at this point may not be the best idea," he says.

Mr. Filderman suggests another kind of hedging: diversification. He points out that over the past three months the Canadian dollar has appreciated 3.9 per cent against the U.S. dollar. Over the same period the Canadian dollar has depreciated 3.4 per cent against the Japanese yen and 3.9 per cent against the euro. Investors who put their money in Japanese or European equity funds would have gotten an extra boost on their returns from the falling Canadian dollar. "When you look to invest outside Canada, you need to look beyond the United States. That's the point of diversification," he says.

So how are investors to know if their foreign equity fund has a currency hedge? In its description of the TD U.S. RSP Index fund, TD Investment Services states: "As assets are primarily held in Canadian dollars, it will not be affected by foreign currency fluctuations." Under the heading "What are the risks of investing in this fund?" CIBC Securities makes a brief mention of currency risk in the description of the CIBC U.S. Index RRSP fund.

The extent of currency hedging -- if any -- in actively managed funds is even harder to determine. "Most actively managed global equity funds may mention hedging or not hedging, but it's up to the manager," Mr. Filderman says. He says investors should talk to their investment advisers or the mutual fund company for a clearer hedge picture.

Investors who see opportunity in an unhedged U.S. equity fund right now may be in for a disappointment, according to Bob Tebbutt, vice-president of risk management at Peregrine Financial Group Canada Inc. "We don't know when the Canadian dollar is going to go back down. It could be tomorrow, it could be years from now," he says.

The meteoric rise of the loonie is being attributed mostly to soaring commodity prices, but Mr. Tebbutt says there are far too many factors weighing on the dollar to make that call. He says that even if commodity prices tumble, the blow to Canadian exports could drive up interest rates and add further strength to the Canadian dollar. "People should recognize there's a currency risk in any foreign equity fund," he says.

Dale Jackson is a producer

at Report on Business Television

© 2007 The Globe and Mail. All rights reserved.

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