Investors have a tendency to over-invest in their domestic market. In behavioural finance this bias is known as “home bias” or “local bias”. For Canadians, it means that instead of building globally exposed portfolios, we prefer to stick closer to home, often investing in Canadian companies trading on the Toronto Stock Exchange (TSX) or other local exchanges.
For Canadians, the problem which results from home bias is lack of diversification. Why? Because Canada’s stock market is highly concentrated in a few sectors (Financials and Resources) and it only accounts for a small percentage of global investment opportunities.
Understanding Currency Risk
In order to build a globally diversified portfolio, Canadians need to look beyond our border, which means buying non-Canadian investments. However, when investing in US, European, or Asian companies trading on foreign stock market exchanges, we use their respective currencies to make the purchase. Therefore, the Canadian investor’s portfolio becomes exposed to other currencies and the movements in exchange rates of those foreign currencies and the Canadian dollar. This is known as foreign currency risk, or foreign exchange (FX) risk.
What exactly is currency risk?
When you (as a Canadian investor whose return is measured in Canadian dollars) purchase investments denominated in another currency (e.g., Euro, USD or Japanese Yen), two factors now play a role in determining your total return: The performance of the investment, and the fluctuations in the currency exchange rate.
Take for example a Canadian investor who buys one share of Company X, trading in Europe at a cost of 100€/share. At the time of purchase, the CAD/EURO exchange rate was 1.7, meaning that it cost the Canadian investor $170 CAD to make the purchase. Now, the investor has decided to sell their investment, but today the CAD/EURO exchange rate is 1.6 – therefore, for 100€ you receive $160 CAD. So, if Company X stock is still trading at 100€/share and there’s no loss on the share price, the Canadian investor would still have a negative return on their investment. The loss is $10 CAD or 5.9%. If the exchange rate had gone to 1.8, then the Canadian investor would have had a positive return of $10 CAD or 5.9%. For a European investor the return would be 0%, in both situations as they’re dealing in their home currency, the Euro.
The fluctuations in exchange rates is currency risk. And, it can have a positive or a negative effect on the total return of a foreign investment.
There’s no ‘one-fits-all’ solution of how to approach currency risk. Investors who don’t understand the effect of exchange rates on investment returns may simply ignore currency risk. While those who understand these dynamics make conscious decisions about how to deal with currency risk within a portfolio.
Managing Currency Risk
Hedging is one way to protect a portfolio from currency risk. Hedging strategies can be complex and require a unique set of skills, different from traditional portfolio management. These hedging strategies are typically executed by using derivatives like currency options or futures (which are outside the scope of this article) and can be expensive to implement, especially in small-medium sized portfolios.
For the purpose this discussion, think of hedging as an insurance policy, where by using (purchasing) other investments available in the marketplace one can protect the portfolio from adverse foreign currency movements. However, the investor also gives up the potential of positive returns which could result through favourable foreign currency movements. Currency hedging removes the influence of currency fluctuations from the return on investment. A Canadian investor and a European investor would have the same return on a euro denominated investment if currency is removed from the equation.
Investment professionals have different views on the value of using currency hedging strategies in equity portfolios. While some believe it’s prudent to remove this risk from the portfolio, others believe the benefit of hedging doesn’t outweigh the cost of hedging.
Long-term investors tend not to be as concerned about short-term currency fluctuations and therefore less likely to hedge currency risk. On the other hand, short-term traders are much more concerned with currency fluctuations in the near-term as foreign exchange rates can have significant impact on returns in the short term.
Currency Risk and Fixed Income Portfolios
Due to the nature of fixed income investments and their role in portfolios, hedging strategies tend to be more commonly used in foreign fixed income portfolios. Typically, a bond will pay semi-annual interest payments to the bondholder and the shorter-term currency fluctuation can have a significant effect on those payments when converted back to the investor’s home currency, positive or negative. Since bond returns tend to be lower than equity returns, currency fluctuations can have a much greater effect on total returns than in the case of equity investments. Furthermore, if the investor is relying on those interest payments for income it’s important that the investor receive exactly the amount they are expecting. For these reasons, hedging against currency risk in foreign fixed income portfolios is more common.
To hedge or not to hedge currency risk?
To determine if your portfolio should be hedged against currency risk speak with your wealth manager. Underlying investments, which foreign currencies the portfolio is exposed to, investment time horizon, and cost of hedging are just some of the factors which determine whether to hedge or not to hedge, and how to set up the hedging strategy.
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