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Inside the Market Worried about currency fluctuations hurting your investment returns? Here’s what - and what not - to do

Investing strictly in Canadian stocks wins you no points for diversification, but there are definite upsides.

One is that the companies are familiar and easy to follow, while another is that you avoid the sometimes destructive, sometimes helpful effects of currency fluctuations on returns from U.S. and international stocks.

Can it be possibly be a net win to ignore the 96.6 per cent of the global stock market outside Canada? Maybe if you’re investing strictly for dividend income and are taking advantage of the dividend tax credit in a non-registered account. Otherwise, you want global diversification to contribute returns at times when the resource- and financials-dominated Canadian market underperforms.

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A Globe and Mail reader recently asked about a portfolio that is primarily devoted to Canadian stocks. “I know I should diversify more into U.S. and other global companies, but the currency exchange is holding me back,” she wrote. “Do I need to worry about exchange rates, or should I just ignore them and invest when there is a good buying opportunity? Note that I already own a couple of Canadian exchange-traded funds with U.S. holdings.”

Given that this reader is familiar with ETFs, an obvious way to deal with currency fluctuations would be to buy funds that use currency hedging. These ETFs offer the return of the underlying index, with currency distortions muted. Many investing pros avoid hedging in the belief that currency’s impact on returns over 10-plus years from foreign stocks tends to fade away. But in the shorter term, hedged ETFs remove any worries related to currency fluctuations.

Regardless of whether currency hedging is used, holding ETFs or stocks from outside Canada is a crucial means of diversification. For example, the Canadian market has only trace exposure to vibrant sectors like technology and health care, while the U.S. market is rich in both.

Investors who buy foreign stocks will need to have their Canadian dollars converted to other currencies at unfavourable rates. Forex is a big profit centre for brokerage firms. Still, the diversification benefits outweigh the negatives.

To reduce costs related to currency conversion, consider using ETFs for hedged and non-hedged foreign exposure. The exchange rate applied by the ETF company should be more competitive than the one your broker applies when you buy foreign stocks directly.

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