Exposure, not speculation, should drive currency decisions

In this Windsor Star article, I provide some basic tips to tackling exposure to the U.S. dollar.  In addition to those tips, it should be noted that taking investment action on currencies based on speculation can be a humbling endeavour.  Instead, advisors and investors should keep the following tips in mind when trying to address portfolio currency risk.

1.      Liability Matching

The most natural way to eliminate currency risk is to dedicate a portion of a client’s portfolio to cover spending in that currency.  For instance, if a client vacations regularly in Florida or Arizona, an allocation to U.S. dollar denominated assets to cover U.S. dollar expenses is a good idea.  While the rising Loonie has made such expenses cheaper in recent years, unhedged exposure can cut both ways.  So matching your expected future spending with your current assets is the best way to avoid having to worry about exchange rate fluctuations.

2.      Diversification Hedge

I have long argued that well-diversified portfolios don’t face nearly as much foreign currency risk as people realize.  For instance, consider a typical portfolio invested 60% in stocks and 40% in bonds.  If we assume that all of the bonds are Canadian (as is usually the case), we generally suggest that the equity component be split it into three equal pieces – i.e. 20% into each of Canadian, U.S., and overseas stocks.

This hypothetical portfolio has 20% exposure to the U.S. dollar.  While the greenback declined about 3.5% per year over the past five and ten years, the 20% exposure reduced portfolio returns by about 0.9% annually over the five and ten years ending March 31, 2010.  That’s significant but pales in comparison to what you could lose by speculating on shorter-term movements.

3.      Targeted Hedge

I am an advocate of hedging currency risk but mainly based on client-specific circumstances. In some areas of the country, many people reside in Canada but work in the U.S.  These clients’ largest financial asset – i.e. their source of income – is already denominated in U.S. dollars.  For such clients, I usually suggest excluding U.S. dollar denominated investments.

I recommend this regardless of my opinion on the currency.  Prudent risk management ensures that the portfolio does not further tilt the client’s total financial exposure to the U.S. dollar.  While many clients are not in border cities, many own U.S. real estate, hold U.S. investments (i.e. 401-k from a former job), receive U.S. Social Security or own a business with U.S. clients.  Each of these scenarios requires, based on client-specific circumstances, some level of hedging at the portfolio level.

The client’s Investment Policy Statement can deal with this either by excluding U.S. holdings altogether, using currency neutral funds or (for large portfolios) considering derivatives to hedge a specific dollar amount of currency exposure.  Any hedging action taken in these cases should be based on an assessment of client-specific risk exposure – not on currency forecasts.

4.      Currency Neutral Funds

Some clients – despite having little or no foreign currency exposure outside of their investments – are too scared to accept any further U.S. or other foreign currency exposure.  For these clients, currency-neutral funds should be considered as a last resort.  No matter how strong or logical an argument to continue unhedged, your client must be comfortable and have confidence in your advice.  In such cases, there are many active and passive funds offering currency neutral exposure to foreign stocks and bonds.

As a final thought, I can recall how advisors and investors were tripping over themselves to pull money out of Canadian stock funds so that they could invest in U.S. and other foreign funds.  At that time, the rising U.S. dollar had added about 3% per year to returns for Canadian investors.  Everybody seemed convinced that the Loonie would continue falling.  And in 2002, some people started talking about merging into a North American dollar.  The ‘crowd’ was completely wrong at that time.  So, when it looks so obvious that the U.S. dollar will spiral downward into obscurity, think about how accurate the conventional wisdom was just a decade ago.