Why foreign currency exposure benefits Canadian equity investors

We find that Canadian investors benefit from retaining currency risk in international equities, as foreign currency acts a natural diversifier that can reduce overall volatility

Diversifying globally provides a range of benefits for Canadian investors (read more here ). However, venturing abroad introduces currency risk. Intuition leads us to believe that because currencies are volatile, exposure to foreign exchange swings in a portfolio can only be detrimental. This isn’t always the case, as we find that the impact of foreign currency exposure on risk hinges on the investor’s home currency. In our view, Canadian investors should embrace currency exposure in equities, as global equity returns have tended to be less volatile when measured in Canadian dollars.

The impact of currency on investment returns

When purchasing foreign securities, either directly or through a fund, an investor is subject to two sources of return: the return on the asset itself and the return on the base currency of the asset. In a given period, this complicates performance because currencies can either boost or detract from returns (see the chart below). In the past two years, the Canadian dollar’s rise against the many other currencies partially muted strong global equity returns. In contrast, the Canadian dollar’s decline in 2015 amplified otherwise tepid global equity returns. We see that currency’s impact on performance has varied significantly in both magnitude and direction.

BLK Investopedia graph May1.1

There are ways individual investors can hedge currency risk to reduce exposure to swings in foreign exchange rates, such as through a currency-hedged exchange traded fund. Hedging would be a plus when the Canadian dollar strengthens, because a depreciation in foreign currencies reduces the value of those foreign holdings. But trying to time currency moves is difficult, to say the least. The drivers that matter most for a given currency – from interest rate differentials and monetary policy to investment flows and investor sentiment – can change quickly.

Toggling currency exposure to improve performance is tricky. In practice, many investment professionals therefore don’t manage currency decisions this way. Under the assumption that hedged and unhedged returns converge in the very long run, which has tended to hold true, we believe volatility reduction should be the focus for the long-term investor.

Currency hedging for the Canadian investor

A portfolio’s reference currency is the starting point for understanding how foreign currency exposure affects volatility. We can broadly classify a currency as either pro-cyclical or counter-cyclical, based on its relationship with changes in global growth and financial market conditions. When an investor’s home currency is pro-cyclical, the investor may actually benefit from being unhedged. How? During market sell-offs, a weaker domestic currency somewhat offsets the weakness in foreign asset holdings. This is often true for Canadian investors (see chart below). For example, in October 2008 the MSCI All Country World Index fell 17% in local currency terms, but in Canadian dollars the decline was only half as bad at -8%.

BLK Investopedia graph May2.1

The chart above shows the relationship between foreign currency returns and global equity returns, from the perspective of a Canadian dollar based investor. The negative correlation tells us the two returns tend to move opposite to one another. When combined, the offsetting effect can compress the range of investment outcomes, which lowers total volatility.

When comparing the unhedged and hedged returns across major developed economies, we find hedging to be uniformly more volatile for Canadian investors. This is despite currency contributing to risk in unhedged equities. We also notice that currency exposure contributes to only a modest portion of unhedged equity risk, suggesting it shouldn’t be a principal concern when investing globally.

BLK Investopedia graph May3.1

What about emerging market equities? The same preference of remaining unhedged applies, but for different reasons. The interest rate differential between emerging and developed markets, which helps bolster emerging market currencies, could provide a source of total return to Canadian investors. Second, hedging emerging market currencies can be impractical or prohibitively expensive, creating a drag on returns.

Bottom line: We believe it makes sense for Canadian dollar based investors to retain currency exposure in non-domestic developed market and emerging market equity holdings.

Kurt Reiman is BlackRock’s Chief Investment Strategist for Canada, and is a regular contributor to The Blog in Canada.

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