Loonie’s race toward parity proves value of hedging

The current pattern of volatility in global currency markets and the recent rally in the loonie against the U.S. dollar are having a menacing effect on the investors with exposure to foreign markets.

Currencies are much more volatile today than they have been in ages — a function of world-wide changes in economic or financial conditions. The long-standing belief that currency volatility eventually comes out in the wash doesn’t have many takers today. Investors nowadays have a shorter time horizon and they don’t want to wait.

The din of conversations about how the rising dollar will have a negative impact on the Canadian economy and the resultant financial panic appear to be reaching a crescendo. Investors and advisors are moving quickly to hedge against the risk of the rising loonie as it shrinks the Canadian dollar return on investments in other denominations, especially in the U.S. dollar.

Som Seif, president of Claymore Investments Inc., is strongly recommending clients hedge against the risk of volatility. His firm’s shelf of exchange traded funds offers investors the choice of hedged or non-hedged exposure to the U.S. market, but right now, he says the choice is clear.

“Take that risk away. Eliminate it by investing on a hedge basis whenever possible. Currency hedging is a very good thing for Canadian investors,” he says.

He is, however, not indifferent to the possibility of the impact of currency fluctuation going the other way. “You have to understand currencies can be negative or positive. So it could go either way,” he says. “The Canadian dollar is strong at the moment, but if it goes in the opposite direction, back to 70 or 80 cents for the U.S. dollar, you can get a large amount of investment potential by investing abroad as a result of that.”

Brent Smith, chief investment officer of Franklin Templeton managed investment solutions, says predicting the short-term direction of currencies is an extremely difficult exercise.

“There is only one reason why you would want to hedge your non-Canadian dollar investments,” he says “If you believe your foreign investments are going to go up but the Canadian dollar will appreciate versus those currencies, then you want to hedge.”

The long-term view on the U.S. dollar remains rather negative, so if investors think the U.S. offers good investment prospects from equities and fixed income, they should be looking to hedge those investments against further erosion in the U.S. dollar, says Smith.

Seif agrees it is very challenging for investors, many of whom are shifting to currency-hedged options. “We offer both hedged and unhedged options. We are having a lot of activity in our currency-hedged vehicles given the current surge in the Canadian dollar. But we have a lot of people who look both ways.”

These are the ones who believe what goes up must come down.

“Our personal view is, think long term,” says Seif. “The Canadian dollar looks attractive relative to the U.S., but we’ve had a very strong move in a very short period of time. It has gone from 93-94 [cents] to 99 [cents] very quickly, so we have to consider if we will see some pull back on that at some point.”

There is hope for those threatened by impending parity. Invest in the emerging markets or Asian investments, Smith says.

“Those currencies will probably appreciate against the Canadian dollar and, therefore, you wouldn’t want to hedge your exposures to those currencies,” he says. “Not only would you hopefully get good returns on the investment, but also pick up appreciation in the currency as well.”

The rapidly fluctuating exchange rates make it rather difficult for investors to decide if the time is right to invest in foreign assets. Experts couldn’t agree more.

“I think it’s a moving target. Currency prices can really stray from what their perceived fair value is,” says Smith. “There is a very strong correlation between the Canadian dollar and improving prospects in the global economy and commodity prices. If all of a sudden there was another financial crisis in our midst, I can guarantee you that the Canadian dollar will go down significantly and investors will look out for the U.S. dollar, supposedly the safe haven, as the risk appetite disappears.”

The risk and difficulty of gauging the value of the Canadian dollar is not lost on Seif either.

“Look at all the currencies around the world. There aren’t many great currencies right now. The U.S. has a lot of economic issues that it’s going to face over the next decade. The Japanese yen has been a terrible market for some time. It is likely not an attractive asset. You can see what’s happening to the euro. Whether the euro would be a long-term currency is another question. When you think of that, it becomes very challenging to value the Canadian dollar. It’s more a question of how you value the denominators, the other currencies,” says Seif.

Most people think, and hope, the Canadian dollar cannot sustain a level above par. Seif has bad news for them. “I don’t think you can say the Canadian dollar couldn’t represent a 105 or 110 and maintain a level above par for some time. There is no real view that Canadian dollar cannot persist in the range of 95 to 105 for a long time.”

(03/17/10)