Leave currency hedging to professional traders

Date: Friday, December 7, 2007
Author: Bill Carrigan, The Toronto Star

The latest investment myth to hit the street is the importance of currency hedging to long-term investors.

A recent commentary from Mackenzie Investments is typical.

"Canadian investors have watched our dollar rise strongly against the U.S. currency over the past few years," says David Feather, president of Mackenzie Financial Services Inc.

"If they've been invested in unhedged U.S. equities, they may have received a diminished return even if the stocks have gone up. These new currency-hedged funds give investors greater choice and the ability to participate in the growth of U.S. equity markets while maintaining control over their exposure to the U.S. dollar."

There is no doubt the advance of the Canadian dollar from 2003 to now has created opportunity for the Canadian investment industry to invent new products to satisfy the "need to feed" by the investment sheep. Today we have hedged closed-end mutual funds, hedged open-end funds and hedged exchange-traded funds.

To better understand currency hedging, let us look at a few hypothetical situations involving the advance or decline of our dollar.

If the Canadian dollar advances or declines against most world currencies, the impact on various components of the economy varies in terms of time. Anything priced in a foreign currency (usually the U.S. dollar) will be affected immediately.

That means things like interlisted stocks, crude, copper and gold will be repriced in terms of the local currency (the Canadian dollar) within seconds of any currency fluctuation. Locally priced things like houses, automobiles, wages, household goods and fine dining have a delayed and muted reaction to currency fluctuation.

It is the volatility of the currency effect on stock prices that gets our attention. I can just picture an investor with a $20,000 (U.S.) exposure demanding a currency hedge and yet not giving a thought to hedging that $500,000 home in North York.

Currency hedging is for active traders and hedge funds. Look at this stock market example.

Nortel Networks Corp. is listed on both the Toronto and New York exchanges and is therefore affected by daily currency fluctuations. On Nov. 7, the Canadian dollar hit its peak against the U.S. dollar and headed back down toward parity. By this past Tuesday, it was down about 10 per cent from its peak.

Over the same time, the New York-listed shares of Nortel lost 11 per cent, while in Toronto, Nortel shares declined only 3 per cent. That is because by Tuesday, we needed more Canadian dollars to buy Nortel and so the Canadian price and the stock's returns were immediately made higher than in New York by our falling currency.

Did you notice any change in the price of houses, autos, bread, clothing and wages over the same time period?

Our chart this week is that of the daily closes of the TSX-listed iShares Comex gold trust plotted above the daily closes of the U.S. StreetTracks gold shares, listed in New York. Both of these trusts represent direct ownership of gold in the local currency with no hedging. The time period closely follows our Nortel trade.

Once again the falling Canadian dollar had an immediate effect on the upper Canadian plot with the current price 5 per cent above the November highs and the lower U.S. plot down about 3.5 per cent over the same time period.

With those trades in mind, what would you do now? Go long U.S. dollar trades? Go short U.S. dollar trades?

Unless you're a day trader, the best strategy for longer-term investors is to diversify your portfolio by asset class and country. Acquire some global content and you will acquire currency diversification, which in turn removes the need to feed on those expensive hedging products.