Currency movements can present an element of uncertainty for Canadian investors holding foreign mutual funds in their portfolios. A declining Canadian dollar can add to the returns of mutual funds that invest in foreign markets, while a soaring Canadian dollar can negatively impact reported returns on foreign investments, particularly U.S. equity funds.
This section explains the effects exchange rate movements have on mutual funds that hold foreign securities. It also discusses how exchange rate risks can be mitigated through currency hedging, and how investors should view currency within their portfolios.
Foreign Mutual Funds
How exchange rates affect foreign mutual fund returns
The impact of exchange rate movements (also known as currency risk or exchange rate risk) applies when you purchase mutual funds that hold foreign securities such as U.S. stocks.
Canadian investors typically purchase U.S. mutual funds using Canadian dollars, but in order to buy U.S. stocks and bonds, fund managers first have to convert this money to U.S. dollars.
It's important to note that most mutual fund unit prices and their rates of return are reported in Canadian dollars, even if it is a foreign fund. As an example, consider the impact that currency can have on a stock's overall rate of return:
| At Time of Purchase | At Time of Sale | Result | |
|---|---|---|---|
| Stock Price (US$) | US$100 | US$100 | Actual stock price stays the same |
| Exchange Rate | CDN$1.40 = US$1 | CDN$1.25 = US$1 | Canadian dollar increases in value |
| Stock Price (CDN$) | CDN$140 | CDN$125 | Stock price in CDN$ declines |
Because mutual funds are valued in Canadian dollars, with all things being equal, when the Canadian dollar rises, the value of a U.S. investment falls (in Canadian-dollar terms). Conversely, if the Canadian dollar declines, the value of the U.S. investment rises.
Exchange Rates Vary Over Time
In addition to impacting performance from one year to the next, exchange rate movements tend to vary over time. While a rising Canadian dollar has negatively impacted Canadian investors holding U.S. dollar investments since 2003 (despite strong gains in the U.S. stock market), the opposite effect occurred throughout most of the 1990s and early 2000. (As the U.S. dollar increased relative to the Canadian dollar during the 1990s, the value of U.S. mutual funds increased when they were converted back to Canadian dollars.)
Source: RBC GAM, January 1999 to March 2014
Exchange Rates Have Less Impact over the Long Term
The example above highlights the variability in short-term exchange rate movements and the impact this can have on investment returns. However, the chart below shows how currency movements tend to have minimal impact over the long term. In fact, over periods of 15 years or longer, the impact of exchanges between the Canadian dollar and the U.S. dollar on investment returns gets closer and closer to zero – an important point for long-term investors.
Currency Hedging Basics
Mitigating the impact of exchange rates
Although the effect of currency fluctuations diminishes over time, there are ways to mitigate the impact of exchange rates in the short term. This process is known as currency hedging. Regardless of how much the Canadian dollar moves after hedging, investors know that there will be limited impact on investment performance due to currency movements.
Hedging Example
A classic example of hedging involves a farmer who sells his wheat to food producers. Each growing season, the farmer knows how much wheat he will produce long before it is harvested a few months later. What he is less certain of, however, is what wheat prices will be once the crop is harvested and sold to food producers. If wheat prices rise, the farmer benefits, but if prices decline, the farmer earns less.
To protect against this uncertainty, the farmer can enter into an agreement early in the growing season to lock in a fixed price for the wheat he will harvest and sell in a few months time. By locking in a fixed price for his wheat, the farmer will know how much he will earn for his crop and will not have to worry about fluctuating market prices. This process of mitigating risk resulting from fluctuating prices is known as hedging.
Currency Hedging Has Drawbacks as Well
The primary drawback of hedging is that if the Canadian dollar falls relative to a foreign currency, the opportunity for higher returns based on exchange rate movement is lost. The upside is that the investment is protected against a rise in the value of the Canadian dollar relative to foreign currencies.
Similar to an insurance policy, the objective of hedging is to remove uncertainty. But just like there's a cost to purchase an insurance policy, there's typically a cost to enter into a hedging agreement. Fortunately, the cost is minimal with solutions like mutual funds given their large size and professional guidance.
The Impact of Currency Hedging: Short-Term vs. Long-Term
While a rising Canadian dollar has negatively impacted returns on U.S. investments in recent years, the opposite effect was seen throughout most of the 1990s. During this time, the U.S. dollar increased relative to the Canadian dollar. As a result, many Canadians received a boost in the value of U.S.-based investments when they were converted back to Canadian dollars.
Although the impact of currency will vary in the short term, the impact over time will be minimal. The charts below highlight both the impact of exchange rate movements from year to year and how over time these fluctuations will tend to offset one another.
Source: RBC GAM, January 1999 to March 2014
Key Currency Principles
Investors shouldn't make investment decisions based on expectations of future foreign currency movements. Here are four reasons why:
- It is almost impossible to predict the timing of currency movements.
Predicting when a particular currency may rise or fall is a very difficult task. In fact, Allan Greenspan, former chairman of the U.S. Federal Reserve, once likened the probability of accurately forecasting short-term exchange rates to that of a coin toss (speaking in November 2004):
"Despite extensive efforts on the part of analysts, to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin." - The impact of currency movements tends to diminish over time.
While exchange rates fluctuate from year to year, the impact of currency on investment returns declines over time. As highlighted previously, over longer time periods, currency movements have very little impact on performance.
- In a diversified portfolio, currency movements tend to even out.
A well-diversified portfolio has exposure to many different currencies. For example, global mutual funds will typically hold securities from the U.S., Europe and Asia – all denominated in different currencies (e.g. U.S. dollar, euro and yen). Often a rise in one currency is offset by a decline in another. The interplay between baskets of currencies is sometimes referred to as a natural hedge.
RBC O'Shaughnessy International Equity Fund and PH&N Global Equity Fund are examples of funds that invest across multiple currencies, providing natural offsets against exchange rate fluctuations. - There's little reward for betting on currency over the long term.
Currencies can fluctuate more in value than the stock market. Over time, investors are simply not rewarded for currency fluctuations the same way they are rewarded in the stock market. The long-term trend for the markets is up.
