The loonie's show of strength this summer serves as a tough lesson on the power of currency movements to spoil returns.
For investors with diversified portfolios, the recent run in the Canadian dollar more than wiped out what were respectable gains in U.S. stocks over the same period.
Now perched at less than a penny below its two-year high, the reinvigorated dollar has forced many Canadian investors to rethink their approach to currency risk.
"The goal posts have shifted," Matthew Barasch, Canadian equity strategist at RBC Dominion Securities, said in a report.
Canadian investors inclined to insulate against currency shifts should now consider hedging their U.S.-dollar exposure if the loonie falls below 77 cents (U.S.).
Above 83 cents, meanwhile – "get more aggressive on U.S. dollar exposure," Mr. Barasch wrote.
"We would expect this range to roughly hold for the next few quarters," barring any major change in the crude oil market, he said.
The decision over whether to hedge against foreign-exchange movement is no simple one and comes down to individual risk tolerance and investment horizon.
For most of the past five years, Canadian investors with unhedged U.S. exposure would have gotten a boost from the exchange rate.
As the Canadian dollar declined from its last visit above parity in 2012-13 to as low as 68.59 cents in early 2016 amid the oil price shock, assets priced in U.S. dollars got a bonus once converted back into Canadian currency.
Upward moves in the value of the loonie have the opposite effect, eroding returns on foreign holdings.
Between early May and late July, the Canadian dollar gained nearly eight cents on the U.S. dollar. Over that same time, the S&P 500 index rose by 3.5 per cent. In Canadian dollar terms, however, that translates to a drop of 6.3 per cent in the index. In other words, the difference in return between a hedged and unhedged position would have been 10 percentage points, in less than three months.
Such rallies in the Canadian currency tend to spark interest in strategies that neutralize the effects of loonie appreciation.
Of course, the best time to hedge would have been in the spring, prior to the loonie's big move. Back in early May, the Canadian dollar was trading below 73 cents as currency traders built up a record-high short position.
The ensuing reversal was dramatic, after the Bank of Canada's tightening cycle surprised the market at the same time as the U.S. Federal Reserve took a dovish turn.
After the loonie surged past 80 cents in late July for the first time since June 2015, the argument in favour of hedging weakened, said Craig Basinger, chief investment officer at Toronto-based Richardson GMP.
"From a fundamental perspective, the Canadian dollar does not appear to be undervalued any more," he said in a note to clients.
There is a strong case for investors to embrace currency risk in general, Mr. Basinger said.
While short-term foreign exchange movements can have a profound impact on portfolio performance, over the very long term, currency fluctuations tend to smooth out.
Over the last 20 years, for example, the gains in the S&P 500 index haven't differed much when expressed in either U.S. or Canadian dollars, Mr. Basinger said. "A few basis points, probably not worth the trouble of hedging in the long term."
Additionally, U.S. dollar exposure can act as a kind of portfolio diversifier for Canadian investors.
When the global economy is doing well, and markets are generally inclined to risk-taking, the Canadian dollar tends to rise along with stock prices.
"The Canadian dollar is typically a pro-risk currency – when there is risk appetite, the Canadian dollar tends to strengthen," said Eric Theoret, a currency strategist at the Bank of Nova Scotia.
The currency effect will tend to offset gains in Canadian and U.S. stocks. Conversely, when investors are fleeing from risk, the safe-haven greenback tends to gain against the loonie, providing an offset from equity losses.
This summer, however, Canadian investors have been made to suffer through the relatively rare combination of a resurgent loonie and declining domestic stock prices.
Only six times in the last 15 years has the Canadian dollar advanced by at least 7.5 per cent in under three months, RBC's Mr. Barasch said. And each instance has coincided with a rally in Canadian equities across nearly every sector – gains which tend to hold over the ensuing year.
The departure from that pattern this time around might be explained by the source of the loonie's strength – a shift in monetary policy. Historically, a rapid rise in oil prices has fuelled most currency moves of that magnitude.
Despite the recent aberration, Mr. Barasch said he finds the traditional correlation between Canadian currency and equity strength "instructive."