Note to investors entranced by our dollar's strength: Do not succumb to currency complacency.
With the loonie settling in at levels above the U.S. dollar, there's a temptation to figure the currency has had its run and no longer represents as big a risk as it has been to your returns from the U.S. and global markets.
The mutual fund company Criterion Investments has worked up some facts and figures suggesting otherwise. Criterion is big into funds that resist currency moves through the use of hedging, so it has a vested interest in keeping investors worried about what the dollar is doing to their global holdings. Still, the firm's analysis is worth hearing.
To start with, Criterion argues that the Canadian dollar's strength lately must be understood not only in comparison to the U.S. dollar, but other global currencies as well. Now, it's widely thought that you don't need to worry much about hedging when you own a broadly diversified global equity fund. The reason: The Canadian dollar's ups and downs against a wide variety of currencies will cancel each other out.
Data that Criterion will shortly make public go some way to refuting this. Using numbers supplied by the indexing people at Morgan Stanley, the firm looked at how the rising loonie would have affected returns in a pair of global stock indexes. One, the MSCI World Index, is about one-third North American; the other, the MSCI Europe Australasia Far East (EAFE) Index, has zero U.S. or Canadian content.
You'd be correct in surmising that returns over the past three years in the world index would have been hurt by the rising dollar. In fact, returns suffered by 27 per cent over the three years to Aug. 31 when converted to Canadian dollars. The more interesting story is in what happened with the EAFE index. According to Criterion, you would have taken a 24-per-cent currency hit with this "everywhere but North America" index. So much for the idea that you mainly need to keep your eye on the Canada-U.S. exchange rate as an investor.
The underlying story here is that our dollar has been doing quite well not only against the U.S. currency, but the British pound (we've up 11 per cent through the first nine months of the year), the euro (up 8 per cent), the Japanese yen (up 11.5 per cent) and the Swiss franc (up 10.7 per cent).
Many in the investing industry would say that moves like this don't matter much in the long term because they'll be offset by future declines in our dollar against global currencies. "We agree," said Ian McPherson, president of Criterion. "But it takes 15 or 20 years. That might be okay for Ontario Teachers [the giant Ontario Teachers' Pension Plan], but for most retail investors it's just not acceptable."
There's a line of thinking that the Canadian dollar is peaking and that its next major move will be down. This would help juice the returns from U.S. and global funds, but don't count on it actually happening. Criterion's data show that past periods of Canada-U.S. currency parity have lasted six to eight years.
Lately, the Canadian dollar has been pushing past parity, which means more pain for the majority of investors with U.S. and global funds that don't use hedging. A growing number of mutual fund companies are bringing out hedged versions of existing products, while Criterion has targeted this market specifically with its hedged fund products. But some in the investment industry as a whole continue to disparage the idea of currency hedging.
A common criticism of funds using hedging is that they cost more to own than conventional funds. Mr. McPherson played down this by saying that hedging costs add only 0.1 of a percentage point to the management expense ratio of Criterion funds, which sounds reasonable.
Much as Criterion is pushing currency hedged global funds, it doesn't suggest that investors use them exclusively. Mr. McPherson's recommendation is to estimate how much upside you see over the next few years for the Canadian dollar against major global currencies in percentage terms. If you think 20 per cent sounds right, then you'd put 20 per cent of your global holdings in a hedged product. If you're not sure at all, a neutral 50:50 mix works.
Criterion's funds are one option for hedged global funds, although they're too new to have much of a track record (year-to-date numbers are strong). Established alternatives include the well-regarded Mackenzie Cundill family of global funds and a pair of exchange-traded funds in the Barclays iShares family that track the EAFE and S&P 500 indexes.
The Canadian dollar has come a long way in the past few years, but that's no excuse for currency complacency. The financial industry and its clients fell into this trap years ago and the ramifications continue every time the loonie ticks higher.
|Year-to-date, as of Sept. 28, '07|
SOURCE: CRITERION BASED ON BANK OF CANADA EXCHANGE RATES
© 2007 The Globe and Mail. All rights reserved.
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