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Loonie situations: How to prepare for any conditions

When the Canadian dollar hit parity with the U.S. dollar in September, it looked like a great time to buy American stocks.

Parity seemed like such a triumph for the loonie. Having reached such peaks, it was reasonable to argue that it would eventually settle lower and thereby increase the value of U.S. assets held by Canadians. Unfortunately, the dollar's next move was higher. It briefly rose above $1.10 (U.S.) this week and then seemed to find a level in the $1.06-to-$1.07 range.

The currency's next move could be up again - CIBC World Markets chief economist Jeff Rubin issued a forecast Thursday that it would hit $1.11 by year's end and then ease back to the $1.05 range in 2008. When you consider how volatile financial markets are these days, it's not unreasonable to see a chance the currency could fall even further.

The point is, no one knows. That's why you have to construct your portfolio in such a way as to benefit you wherever the dollar heads. In this edition of the Portfolio Strategy, we'll look at some blueprints you can use for building your U.S. and global holdings.

There are three things to consider when evaluating the foreign content in your portfolio.

Allocation: What percentage of your stock and bond holdings will you invest outside Canada?

Security Selection: Which mutual funds, exchange-traded funds or stocks will you buy?

Currency hedging: Do you want funds that use financial tools called derivatives to block out the effects of a rising or falling dollar on the value of their holdings, or do you want an unhedged approach that lets the dollar have its way.

We'll look at the second two issues here - security selection and currency hedging - as they relate to the part of your portfolio devoted to foreign stocks. The point of this exercise is not to tell you which funds or ETFs to buy -you'll need to do your own research on that count - but rather to demonstrate how your view on the dollar can influence your mix of funds.

View One: The sky's the limit for the Canadian dollar.

Thesis: The Canadian dollar is going higher and the near-term downside risk is minimal.

Approach: Uses a heavy measure of hedged funds to protect against further gains in the dollar.

Notes: The easiest way to get hedged exposure to global markets is to use a pair of exchange-traded funds listed on the Toronto Stock Exchange. The iShares Cdn S&P 500 Index Fund gives you the returns of the S&P 500 index minus a little bit to cover fees, while the iShares Cdn MSCI EAFE Index Fund tracks the MSCI Europe Australasia Far East Index.

Hedged exposure to the U.S. market is a must if you're worried about more increases ahead for the Canadian dollar. Hedging is less necessary when you're dealing with funds that include multiple countries and currencies, but it's worth noting that the loonie has done reasonably well this year against currencies that dominate the EAFE index.

Mackenzie Cundill Value and RBC O'Shaughnessy U.S. Value are mutual funds that have used hedging for ages and delivered very good long-term results. Dynamic Power U.S. Growth has been stunningly good lately, which makes you wonder if you'd be buying at a peak right now. It's included here to show how even a Canadian-dollar bull should plan for a falling loonie by having at least some exposure to a non-hedged fund.

View Two: The loonie's bird is cooked.

Thesis: The Canadian dollar is going down, and it won't be by just a few cents.

Approach: Uses almost exclusively unhedged funds and ETFs so as to capture the extra value a falling dollar adds to holdings valued in U.S. dollars.

Notes: The Canadian dollar has been so unpredictably volatile lately that you can't rule out further increases, even while maintaining a view that the currency is overvalued and headed lower. That's why this portfolio has one-fifth of its assets in hedged foreign ETFs.

The rest of the holdings are divided into three mutual funds that don't use hedging. The Trimark Fund SC (this is a low-fee version sold that you may have to pay a small commission to buy) is one of the country's oldest and most successful global equity funds, but it's been a bit of a dog lately. A falling Canadian dollar would undoubtedly help.

McLean Budden American Equity is run by pension fund managers and you need $10,000 to buy in. If you can afford that, you'll have a fund that has produced far above average results without the benefit of hedging. A falling dollar would put a wind at the back of the people running this fund. The final name, Chou Associates, was included because it's the type of fund that just might do well if the dollar's falling and pretty much everything else is going wrong on the markets, too. It was a major money maker in the last bear market.

View Three: Welcome to the new normal.

Thesis: The Canadian dollar may move a few cents up or down, but it's going to stabilize at current levels.

Approach: Emphasizes the use of solid funds and makes hedging a secondary consideration.

Notes: Here, we're using ETFs offered by Claymore Investments, the No. 2 player in the Canadian market behind the Barclays iShares family. Claymore ETFs are newer and less proven, but they include a good variety of both currency-hedged and unhedged funds. Results to date from many of these ETFs have been quite good, incidentally.

It has to be said that you can build portfolios using just ETFs or mutual funds, but there's a lot to be said for mixing the two.

ETFs, which trade like stocks, offer low ownership fees and they're quite flexible in terms of strategically dropping some hedged content into your portfolio. Funds have much higher management expense ratios, but they're more accessible to the average investor (you don't need a brokerage account) and they offer access to more strategies and investing approaches than ETFs do.

The two mutual funds selected for this portfolio have strong records, but they're by no means automatic choices. Be sure to research the entire field of global and U.S. funds using a source like Globefund.com.

View Four: Simple is good.

Thesis: Investors who want a conservative approach that covers them for all market conditions are best served by making equal bets on hedged and unhedged funds.

Approach: 50:50.

Notes: The idea here is to construct a simple, file-and-forget portfolio that won't need a lot of monitoring and won't be completely offside if the dollar lurches up or down. This explains the even split between hedged and unhedged funds, and between ETFs and mutual funds.

In the other portfolios, we've used ETFs as an easy way to grab some hedged foreign exposure. In this case, we'll get hedging from a pair of very solid mutual funds and use ETFs for the unhedged part of the portfolio.

The two ETFs used here are listed on the American Stock Exchange, which is accessible through any broker. Both are issued by Vanguard, a U.S. company renowned for having the lowest fees in the mutual fund and ETF worlds. The total stock market ETF gives you the entire U.S. market, including big and small companies, while the all-world ex-U.S. fund is a complementary fund that covers the world beyond U.S. shores.

Four scenarios

PORTFOLIO ONE: The sky's the limit for the Canadian dollar

MER1-yr. return to Sept. 305-yr. return to Sept. 30Uses hedging
25% iShares CDN S&P 500 Index Fund (XSP-TSX)0.24%15.53%8.25%Yes
25% iShares CDN MSCI EAFE Index Fund (XIN)0.50%13.97%13.22%Yes
20% Mackenzie Cundill Value Fund2.46%5.66%12.26%Yes
20% RBC O'Shaughnessy U.S. Value Fund1.57%7.85%13.00%Yes
10% Dynamic Power American Growth Fund2.55%36.62%13.96%No

PORTFOLIO TWO: The loonie's bird is cooked

10% iShares CDN S&P 500 Index Fund (XSP-TSX)0.24%15.53%8.25%Yes
10% iShares CDN MSCI EAFE Index Fund (XIN)0.50%13.97%13.22%Yes
40% Trimark Fund (SC)1.61%9.60%7.88%No
30% McLean Budden American Equity1.25%5.83%6.74%No
10% Chou Associates1.74%1.86%10.52%Not generally

PORTFOLIO THREE: Welcome to the new normal

10% Claymore U.S. Fundamental Index ETF (CLU-TSX)0.65%10.93% n/aYes
10% Claymore Intl Fundamental Index ETF (CIE-TSX)0.65% n/a n/aNo
10% Claymore BRIC ETF (CBQ-TSX)0.60%89.60% n/aYes
35% RBC O'Shaugnessy U.S. Value1.57%7.85%13.00%Yes
35% Brandes Global Value2.60%0.93%9.70%No

PORTFOLIO FOUR: Keep it simple

25% Mackenzie Cundill Value Fund2.46%5.66%12.26%Yes
25% RBC O'Shaugnessy U.S. Value1.57%7.85%13.00%Yes
25% Vanguard Total Stock Market ETF (VTI-Amex)0.07%14.98%15.14%No
25% Vanguard FTSE All-World ex-U.S. ETF (VEU-Amex)0.25% n/a n/aNo

DOUGLAS COULL/THE GLOBE AND MAIL 66 SOURCE: GLOBEINVESTOR.COM

© 2007 The Globe and Mail. All rights reserved.

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