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Currency hedges: The pros and cons for foreign stocks

Money managers differ on how to cope with volatility

Currency swings can quickly erase hard-won gains in a portfolio, but money managers at most of Canada's largest equity mutual fund groups with billions of dollars in foreign holdings do not hedge or insure their portfolios against exchange rate fluctuations.

Andrew Massie, vice-president investment management and a portfolio manager with the Mackenzie Cundill group, says that to his knowledge, Cundill managers are "pretty much the only guys in Canada" that take such precautions full time."

Volatile currencies are a two-edged sword in that they have the potential to help or wreak havoc on a portfolio.

In 1998, the latest time the yen carry trade suffered a major breakdown, the yen climbed 35 per cent over five months against the U.S. dollar. The yen carry trade refers to borrowing of money at low interest rates in Japan and reinvesting it in higher-yielding securities and emerging markets.

In 2002, the Canadian dollar began to soar, effectively wiping out hard-won stock market gains that Canadian investors had earned on their U.S. portfolios.

The Cundill group has $9.7-billion under management in five retail funds that are invested outside of Canada. Over all, Cundill's assets under management total $17-billion. Cundill funds typically hedge or insure about 85 to 90 per cent of their portfolios against foreign currency risk where it is economically feasible to do so.

The aim is to insulate or neutralize the impact of currency swings on the portfolios, Mr. Massie said. "The cost of hedging is pretty well zero or close to it." In fact, hedging against yen swings has been profitable because of the interest rate differentials, while the cost of hedging against moves in the euro or British pound has been marginal.

The technique Cundill uses is futures contracts, which eliminate the risk of fluctuating exchange rates, by locking in a price of one currency against another (spot price) for a pre-agreed transaction in the future when the contract expires. The cost is the difference between the spot and future price.

Cundill's point of view is that it is very difficult to accurately predict currency swings. And because, as deep value investors, Cundill money managers put so much effort into evaluating each security owned, their funds' performance should reflect stock-picking ability rather than positive or negative currency movements, Mr. Massie said.

Elsewhere, money managers think differently. "Hedging is a money loser for us," said Don Reed, president and chief executive officer of Franklin Templeton Investment Corp. In the long run, currency fluctuations tend to average out and hedging isn't cost effective, he said.

Franklin Templeton's latest study two years ago indicated the unhedged return on the MSCI world equity index (Morgan Stanley Capital International Inc.) was at an annual rate of a little more than 7 per cent over a 15-year period, compared with a return on a hedged portfolio with all costs rolled in of slightly more than 5 per cent. There was little change in the overall risk or volatility with either strategy.

In studies over the past 25 years, Franklin Templeton has found that -- even assuming perfect hedging strategies over a five-year period (its corporate research bases its stock recommendations on expected five-year returns) -- that hedging costs exceed the gains.

The Templeton Growth Fund has $5.3-billion in assets under management, while the Templeton International Stock Fund has $2.6-billion in assets.

"You can talk about a perfect hedge, but there's not a lot of countries you can hedge in," especially in the Far East and emerging markets, Mr. Reed said.

"Global companies tend to have their own internal hedging systems going on," Mr. Reed said. "We would in fact be hedging the hedgers."

At Toronto-Dominion Bank, the flexibility to manage or hedge currency is looked at on a fund-by-fund basis, said vice-president Karl Schultz. UBS Securities is subadviser to the TD International Equity Fund, but it hedges only 5 per cent of the $800-million in assets under management.

"We do not hedge across global equity funds," said Stephanie Nacawa, vice-president of product research for Fidelity Investments Canada Ltd. "Investors [in diversified portfolios] want full exposure to the market."

However, it is quite common for mutual fund groups to hedge fixed-income portfolios where currency moves can critically affect the overall return.

Fidelity does offer investors the option of a currency-neutral (a hedged position) or unhedged investment in its U.S. high-yield and its global bond funds, Ms. Nacawa said.

"With the recent low volatility of fixed-income markets, currency [volatility] has been a good source of added value in recent years," said Jean Charbonneau, a fixed-income portfolio manager for AGF Funds Inc. But AGF equity managers typically tend to be unhedged, he said.

© 2007 The Globe and Mail. All rights reserved.

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