contributed by John E. Rice, CFA, CFP®
For those who pause to think about it, one of the more complex decisions in investing is exposure to other currencies. Like other financial assets, currencies fluctuate, and your exposure to currencies outside your “home” currency can have a dramatic impact on your future purchasing power.
Making financial decisions in the face of uncertainty is always difficult. There is no shortage of opinions on where the stock market, interest rates, or the US dollar are headed. But you don’t really know. On top of the uncertainty, we all suffer from overconfidence bias where we think we have the ability to forecast these movements more than we really do.
The good news is that, at least on the currency front, you can get exposure to currencies easily without going through the actual process of foreign currency conversion. A classic example will illustrate this.
Let’s say you are a Canadian that has moved to the US and wants exposure to the Canadian dollar (CAD) because you think CAD will appreciate against the US dollar (USD). But your portfolio is priced in USD.
The most common two ways to get this exposure would be to:
- Convert USD to CAD, invest in Canada, sell at end of period and convert back to USD.
- Buy CAD denominated investment in your USD portfolio, sell at end of period.
The end result of either of these options is going to leave you roughly in the same place. There will be a few differences if your investment pays dividends that get converted along the path instead of at the end, but your overall return should be very similar.
So you can invest in a USD portfolio and still get the currency exposure you want.
But that doesn’t answer the question of how much exposure should you have to different currencies. This really comes down to a question that is similar to many of the active investment decisions. Do you believe you can correctly forecast currency movements with sufficient accuracy to make profits in excess of the additional costs and taxes you will pay with the additional activity? If you realistically assess your ability to forecast both the direction and timing of currencies you may decide that you don’t want to be a currency speculator. Then you should take the approach of diversifying across a large spectrum of investments to hedge the possibility of being wrong on your bet, thus preserving your wealth.
Another consideration is to tie your currency investment decisions to your future spending. If you are spending some time in Canada each year you should have some of your portfolio hedged back to the Canadian dollar.
At KeatsConnelly we take the approach of diversification across a broad spectrum of investments, including currency. We look at the income and growth components of portfolios separately. In the income side we generally hedge most currency exposure back to the home currency. The reason we do this is because currency volatility can swamp the income return in some years and since we have the income allocation primarily as a hedge against volatility in your portfolio, we believe in hedging out the currency volatility in the income allocation.
On the growth side, we primarily buy assets that have exposure to currencies. We invest in foreign stock markets in rough proportion to their world market capitalization and we do not hedge back to the home currency. This allows for the additional exposure to world markets that hedges against potential depreciation in the home currency.
In the last decade there was a trend towards depreciation of USD relative to other currencies until the financial crisis hit in 2008. Then there was a spike up in USD. For the past five years the trend has been to a higher USD every time the fear index increases. Then, when markets calm down people reach into other markets and the USD resumes its decline against other currencies.
We believe it is likely that USD and other developed market currencies will, on average, depreciate against emerging market currencies over time. There will undoubtedly be exceptions to this trend as some emerging market economies will be unable to navigate a smooth transition, and hyperinflation and debt will devalue their currencies. Despite this, the US dollar will continue to serve as the world reserve currency for the foreseeable future.
So investors are best served with a diversified approach to currency management. Get some exposure to currency in the growth components of your portfolio and hedge the income components back to your home currency to reduce volatility. If you will be spending portfolio income in more than one country we will look to get exposure to the currencies where your future spending will occur.
photo courtesy of epSos.de