What do you recommend investors do now that the Canadian dollar is rising against the U.S. dollar?
When it comes to currencies, Canadian investors face a dilemma.
On the one hand, we're told that Canada makes up only a small percentage of the global economy and we need to diversify by buying U.S. and international stocks or funds. On the other hand, spreading our cash around the globe exposes us to currency losses if the loonie strengthens.
Sometimes, diversifying abroad can seem like a really bad idea.
This week, for example, U.S. tech stocks tumbled at the same time the Canadian dollar shot higher. Result: As of Friday afternoon, a Canadian investor who purchased Google parent Alphabet would have suffered a loss of more than 7 per cent in Canadian dollars over just the past five trading days. Ouch.
Of course, it also works in reverse. Canadian investors who owned U.S. stocks when the loonie was plunging from more than $1 (U.S.) in 2013 to less than 70 cents in early 2016 enjoyed a huge currency windfall in addition to hefty gains on their U.S. stocks.
So what's the best way to control currency risk while still partaking in the wider world of investing opportunities? Here are four suggestions.
Limit your exposure
The simplest method is to cap your foreign exposure.
As a general rule of thumb, I like to invest no more than about 10 per cent of my equity portfolio in U.S. stocks. That way, I get to own some great U.S. companies, but I won't have a panic attack if the loonie surges. The 10-per-cent rule is just my personal preference; you may want more, or less, U.S. exposure. I tend to relax this rule when the Canadian dollar is trading at or near par simply because the odds of a meaningful rise in the loonie are reduced when it has already had a big run.
Tip: If you categorize your stocks by settlement currency – that is, you keep Canadian stocks on one side of your account and U.S. stocks on the other – changes in the exchange rate won't affect the market value of your U.S. holdings. Your U.S. dividends will also remain in U.S. dollars, which is handy if you make regular trips to the states, for example.
Also keep in mind that many Canadian-listed companies – utilities, pipelines and banks, among others – have extensive U.S. operations, so your portfolio may be more diversified geographically than you realize.
Buy a currency-hedged ETF (or not)
The investment industry knows that some people hate currency volatility. That's why fund companies offer a plethora of currency-hedged products. These funds attempt to minimize or eliminate the impact of currency swings by entering into forward agreements that effectively lock in the current exchange rate.
Bear in mind, however, that there are costs involved in currency hedging and it's not perfect, which means your returns could differ from the index you're trying to track.
Justin Bender of PWL Capital examined the returns of two ETFs – the currency-hedged iShares Core S&P 500 Index ETF (XSP-TSX) and the non-hedged iShares Core S&P 500 ETF (IVV-NYSE) – from 2006 through 2011 when the U.S. dollar fell by 12.8 per cent against the loonie. "In theory, this time period would have been ideal for investing in U.S. currency-hedged ETFs," Mr. Bender wrote. In reality, however, XSP provided no benefit over IVV: Both ETFs returned minus 0.1 per cent annualized in Canadian dollars, even though the S&P 500 index posted an annualized return of 2.3 per cent in U.S. dollars over the period.
Look at the big picture
A rising Canadian dollar might seem like a bad thing if you hold U.S. stocks, but it's not necessarily that simple. A stronger loonie might also reflect a generally weakening U.S. dollar, which is beneficial for U.S. companies that generate a large portion of their revenues abroad. So, even though you would lose on the Canada-U.S. exchange rate if the U.S. dollar falls, your U.S. companies could see their earnings and share prices rise, offsetting all or part of the damage.
It's also important to realize that holding U.S. assets has diversification benefits. The Canadian dollar tends to do well when global economic growth is strong and commodity prices are rising – conditions that also favour Canada's resource-heavy stock market. When commodity prices fall, the U.S. dollar often strengthens versus the loonie. Therefore, holding U.S. assets can soften the blow for Canadian investors when our stock market is in a funk.
Learn to roll with it
Volatility is a fact of life with investing, and currencies add yet another layer of uncertainty. Structuring your portfolio to control the impact of currency changes is the first step in dealing with exchange-rate volatility. But you must also learn to accept that your portfolio will at times be hurt by these currency swings, while at other times it will benefit. If you follow a disciplined investing plan – by owning a diversified portfolio of solid companies or funds, holding them through good times and bad and reinvesting your dividends along the way – you will prosper no matter what the currency markets throw at you.