Currency hedging on the rise

(September 2006) Since the elimination of the foreign property rule, Canadian investors have been increasingly interested in holding foreign investments. Sure, there have always been ways around the 30% limit, but few retail clients were reaching that threshold.

First to take advantage of the change were pension funds, which served to convince retail investors that overseas markets were the place to be. According to StatsCan, Canadians acquired $38.7 billion in foreign securities in the first six months of 2006 alone.

Conditions seemed to favour the move, to some extent. While equity prices had already climbed off their earlier lows, there were bargains to be had — in the U.S. at least — thanks to the soaring value of the Canadian dollar.

Currency hedging used to be relatively rare among retail investments, but there appears to be a trend developing in offering such protection. In the first week of September alone, there have been several new offerings launched, and it has not been restricted to niche players.

TD Asset Management has launched five currency-neutral versions of existing U.S. equity funds. RBC also offers currency hedging on a handful of international and U.S. funds, including a mid-cap offering.

IDA-licensed brokers are not being left behind, as Claymore ETFs is launching Canadian-dollar hedged products offering exposure to the FTSE RAFI Japan index and the FTSE RAFI U.S. index.

One firm has even gone so far as to make currency hedging its raison d’etre. Criterion Investments is a relatively new player in the fund industry, representing a foray into the sector by alternative asset manager VenGrowth.

“In building our firm, it’s not lost on us that we need to find our niche in the world,” says Ian McPherson, president of Criterion Investments. “The Canadian public needs another basic mutual fund company like it needs a hole in the head.”

Criterion offers three different currency-hedged funds, a Global Dividend fund, an International Equity fund and a Diversified Commodity fund.

The funds were launched in late spring, inspired by demand from advisors who wanted to increase their client’s foreign exposure, but who were nervous about the currency risk. Aside from the high concentration of the Canadian market in materials, energy and financials, advisors were concerned about valuations in Canada.

With the loonie at its highest value in decades, it may seem like an odd time to adopt a currency-hedging policy. But that hasn’t stopped one fund company from forging ahead with just such a strategy.

“Our idea isn’t timing oriented. It comes from discussions with a lot of advisors,” says Ian McPherson, president of Criterion Investments. “These products weren’t developed in a vacuum — there has been contribution from top advisors.”

He says hedging is all about reducing risk, not timing the currency market. If timing played any part in introducing these funds, it was the timing of the federal government’s abolition of the foreign-property rule for registered accounts.

“Canadians really benefit from globalization to optimize their efficient frontier,” McPherson believes. “The flaw is that in doing so, Canadians are vulnerable to considerable currency exposure.”

Academic models that demonstrate currency’s long-term reversion to the mean overlook the fact that most investors have a much shorter time horizon, he points out. Investors want their money when they want it, and will not be receptive to suggestions that they wait for currency losses to be recovered.

“The old pearl of wisdom is that, in the long run, currencies don’t matter — every fund company and every piece of academic literature will talk about that. The point is, the time horizon in this context is 20 to 25 years. When you ask brokers if their clients have a 25-year time horizon, they laugh. The average mutual fund is held for 2.9 years.”

Even if one accepts the premise that exchange rates balance out over time, McPherson points out that the expected 0% return means the risks of currency fluctuation are not compensated.

“Most people are willing to take on risk if they get compensated for it … but with currency, you don’t.”

Even the longest time horizon for Canadian investors should be at least partially hedge, McPherson argues. Most Canadians invest in mutual funds as the cornerstone of their retirement savings. And since most intend to retire in Canada, hedging becomes a simple question of matching assets to liabilities.

“They need to have Canadian dollar assets to live a life in Canadian dollars. They’re not going to live their life in yen or euros,” he says. “Currency has a huge impact on volatility. I don’t think there’s any one factor that has more impact on your investment returns than foreign exchange exposure.”

The majority of foreign investment funds do not hedge their currency exposure, as the expected impact over the long term is often cited as nil. Over the short term, many managers say currency fluctuations can provide added returns.

Unhedged assets are an all-or-nothing bet, McPherson argues. Advisors whose clients will accept some currency volatility can opt to place a smaller portion of the portfolio into a hedged fund, thereby reducing the inherent risk of the unhedged positions.

If the investor believes there is a 40% chance the Canadian dollar will rise, McPherson suggests they should apply a currency hedge to 60% of their assets.

“It’s an easy story for advisors to tell clients. I believe that Canadian investors need to keep their books simple. They don’t keep track of the TSX, they don’t know what the price of gold is, but they know two things, universally: They know the price of gas at the pump and they know the U.S. dollar exchange rate. They know it’s cheaper to go to Florida now, but they know it’s killing their portfolio.”

Another way of explaining it to clients is with an analogy of being on a flight to Europe. The passenger does not know if they will have a tailwind or a headwind, but either will affect flight time by one hour. With a currency hedge in place, a third option becomes available: no wind at all and they will arrive on schedule.

One common criticism is that currency-hedging programs represent an additional level of expense for the client.

“It’s 15 basis points per year. We think that’s incredibly cheap insurance,” says McPherson. “Generally, currency impacts you plus or minus 10%, every five years, so 15 basis points is extremely cheap.”

The currency-hedging program is performed separate from the investment management, with portfolio managers simply focusing on maximizing returns. Criterion’s currency manager looks at the Canadian dollar exposure to every currency represented in the portfolio.

For example, for a $100 investment in a security priced in UK pounds, the currency manager takes an offsetting position in the currency futures market. If there is a shock to the currency market that boosts the Canadian dollar by 3%, but the price of the security is unaffected, the position would decline to about $97.09 ($100 / 1.03 = $97.087). At the same time, the offsetting position in the currency market would rise along with the Canadian dollar, earning back the $2.91.

“As we point out, there’s more to life than the U.S. dollar. In one of our funds, there’s no U.S. exposure,” he says. “There are more currencies than just the U.S. dollar — there’s euro, yen, the pound — if you go to a lot of Canadian banks, they don’t even forecast those currencies.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(09/08/06)