If you have a diversified investment portfolio (for more information about portfolio diversification, see this infographic), it likely contains investments outside Canada, such as mutual funds* that invest in U.S. companies. This is a widespread practice, since Canada only represents about 3% of global markets: it’s a way of exposing a portfolio to investment opportunities that may be less available in Canada. 

As a result, however, you end up making two investments in one: the foreign securities in question and the foreign currency they are held in. This adds another, perhaps unsuspected, element to the investment risk: currency risk. 

To explain, let’s look at an example. 

Two investments for the price of one 

Let’s say that, with the help of your advisor, you invest $10,000 in a U.S. equity mutual fund. You make your purchase in Canadian dollars within your Canadian account, but the fund manager has to buy stocks on the U.S. market, where it trades in U.S. dollars. Now let’s suppose that the exchange rate is US$0.75 per CAN$1.00. You have just made a purchase for $7,500 in U.S. dollars. 

Suppose that one year later, the fund has gained 10% and your investment is now worth US$8,250. What is your return? That will depend on the exchange rate. If the Canadian dollar has gained in value, for instance, and now trades at US$0.80 (CAN$1.25 per US$1.00), your investment is now worth US$8,250 x 1.25, or $10,312.50. Your return is thus 3.12%, not 10%. Conversely, if the Canadian dollar has lost value and now trades at, say, US$0.73 (CAN$1.37 per US$1.00), your investment will amount to US$8,250 x 1.37, or $11,302.50 – a return of over 13%. 

In short, if the value of the Canadian dollar rises against the currency the securities are traded in, this will reduce the return; if it drops, this will increase the return. 

Does it matter?

Is this currency risk important to an investment strategy? Yes and no. Based on the following graph, we can guess that the Canadian dollar’s strong upswing in the mid-2000s put some serious downward pressure on the performance of U.S. equity funds held in Canadian portfolios. On the other hand, the graph also shows that the exchange rate for these two currencies is about the same today as it was in the middle of the last decade – and each preceding decade – with the result that the exchange rate has a much less significant impact over these long periods.  

So your Canadian-dollar returns depend entirely on when you buy and sell an investment, or on when the return is calculated, notably for your year-end performance statement. 

Can this risk be neutralized? 

There are two strategies, known as “hedging,” that use specialized financial instruments to mitigate the effect of currency fluctuations. These strategies are primarily used by commercial enterprises who buy or sell products in foreign countries and for whom currency fluctuations could quickly translate into major financial losses. With individual investors who are in it for the long term (for example, saving for retirement), these strategies are more rare, although they are offered by some mutual funds. 

In fact, by reducing the currency risk, such strategies also reduce the upside potential should the exchange rate move in a favourable direction. In the past ten years, the annual compound growth rate of the S&P 500 Index was 14.22% in U.S. dollars. In Canadian dollars, that amounted to annual growth of 16.95% because the loonie depreciated against the U.S. dollar. With a hedging strategy in place, however, the annual growth would only have been 13.12%, which is lower than the U.S.-dollar return due to hedging costs. For this type of approach to be of benefit, there needs to be strong, long-term appreciation of the Canadian dollar. In any other circumstances, it is often considered to be better to let exchange rates do what they will, with an impact that is sometimes positive, sometimes negative. 

In conclusion… 

As we can see, while a stronger loonie might be good for vacationers visiting Uncle Sam, it could give them an unpleasant surprise when it comes to their investment portfolios. Fortunately, the reverse is also true! 

If you find this topic interesting, feel free to discuss it with your advisor. 

* Mutual funds are offered by group savings representatives at SFL Investments, a financial services firm.