Currency risk in a retirement portfolio

In late January, the loonie flirted with $0.90 USD, its lowest level since the summer of 2009. For retirees who spend time in the US and abroad, a falling loonie makes travel much more expensive. It also underscores the importance of currency diversification in an investment portfolio: a declining Canadian dollar boosts the returns for foreign stocks. But getting that exposure without taking undue risk requires some thoughtful planning.

You don’t need to trade in US dollars. The most obvious way to add US-dollar exposure to a portfolio is to purchase stocks or ETFs on the New York exchanges. But this option isn’t available to mutual fund advisors, and it often involves converting currency with high spreads.

A more efficient option may be to use Canadian mutual funds or ETFs whose underlying holdings are in US stocks. These funds—unless they use currency hedging strategies, which we’ll discuss in a moment—are bought and sold in Canadian dollars but offer the same exposure to the US dollar.

Get outside the US. The US dollar isn’t the only foreign currency Canadians are exposed to, though it’s certainly the one clients focus on. Ask them whether the loonie depreciated against the yen last year and most will have no clue. (For the record, it did not.) But the yen, euro and British pound are all significant exposures for Canadians who hold international equities. Diversifying across many foreign currencies, and not just the US dollar, can further lower volatility in a global equity portfolio.

Understand how hedging works. Canadian mutual funds and ETFs that hold foreign stocks sometimes include terms such as “CAD-hedged” or “currency neutral” in their names. These funds use futures contracts to remove (or at least reduce) the effects of currency fluctuations. The strategy is a benefit when the loonie appreciates dramatically, as it did from 2003 through 2005, and again in 2009.

But there’s always a trade off: when foreign currencies appreciate against the loonie, currency-hedged funds will not get an equivalent boost in returns. And even if the fluctuations are a wash over the long term, hedging can be expensive and imprecise, which can lead to a drag on returns.

Avoid currency risk in fixed income. Although currency diversification is a benefit when it comes to equities, it should usually be avoided in fixed income. Bonds should play a stabilizing role in a balanced portfolio: they have much lower volatility than stocks, and they will rise in value if interest rates fall during periods of market turmoil. However, all of that changes when you take currency risk: fluctuations in exchange rates can easily make your bond holdings just as volatile as stocks. If you want to diversify with US or international bonds, it generally makes sense to do so with a fund that uses currency hedging.