If you’ve ever travelled outside of Canada, you’ve experienced currency fluctuations. To buy anything in a foreign country, you have to exchange your Canadian dollars for local currency. If you have money left over when you come home and you want to convert it back into Canadian dollars, you may find that the exchange rate is better or worse than when you acquired your foreign currency. If you bought an item on your credit card while abroad, you may discover that the exchange rate changed slightly between the time you made the purchase and the time the credit card company processed it.
Similarly, when portfolio managers buy investments in foreign countries, they have to exchange Canadian dollars for the local currency to make the purchase. When it’s time to sell an investment, the sale is made in the foreign currency and the proceeds are converted into Canadian dollars. In the meantime, however, the value of the Canadian dollar may have changed in relation to the currency used to invest. That can detract from or add to the investment’s return, depending on whether the relative value of the Canadian dollar has gone up or down.
Whenever you invest in a mutual fund, there is a risk that the value of your investment could decrease. If you own a mutual fund that invests outside of Canada, there is the additional risk that the value of the currency used to buy or sell the investments may change. This is called currency risk.
Currency risk example
| At par $1 CDN = 1 unit of foreign currency | A mutual fund invests in a foreign company when the Canadian dollar and the local currency are at par. This means the currencies can be exchanged at equal value. |
|---|---|
| Stronger Canadian dollar $1 CDN = 2 units of foreign currency | Several years later the fund sells the investment, when the Canadian dollar is much stronger. In fact, it’s worth twice as much as the foreign currency. Let’s assume that the price of the foreign investment (calculated in the local currency) has not changed. But because of the currency fluctuation, the value of the investment in Canadian dollars has dropped significantly: for every two units of local currency, the fund would only get $1 Canadian back. |
| Weakened Canadian dollar $2 CDN = 1 unit of foreign currency | If the Canadian dollar weakens compared to the local currency, so that the Canadian dollar is worth half the foreign currency, the fund would benefit. For every unit of the foreign currency, the fund would get $2 Canadian. |
Practically speaking, it’s unlikely the Canadian dollar would be worth twice or half as much as a foreign currency after only a few years. But even small fluctuations in exchange rates can affect the value of your investment.
What is currency hedging?
Currency hedging is a kind of insurance on your investment that aims to reduce the effects of currency fluctuations.
To hedge an investment, portfolio managers establish a related investment designed to offset the negative impact of currency fluctuations.
Different approaches to currency risk
There are three main approaches to currency risk:
Unhedged
1. Ignore the potential risks and rewards from currency fluctuations and focus on getting good returns, in the belief that, over the long term, currency fluctuations will tend to even out.
Hedged
2. Try to negate the risk by hedging. The portfolio manager aims to maintain a static currency exposure in a portfolio at all times. This means hedging all or part of the fund’s foreign currency exposure.
Active
3. Try to earn additional returns or mitigate risks from currency fluctuations. The portfolio manager decides whether or not to hedge, and how much to hedge, based on current conditions and his or her outlook. This is called an active or tactical approach.
The chart below illustrates how each of the three approaches to currency risk might work. The columns show the return of a fund that operates in Canadian dollars and invests in the U.S. (The example assumes that there are no changes in the value of the mutual fund itself.) The unhedged portfolio is fully exposed to the currency fluctuations. The fully hedged portfolio is not affected. The 50% hedged portfolio experiences modified gains and losses, compared to the unhedged portfolio. The active portfolio is dependent on the individual portfolio manager’s decision.
| $1 CAD = $1 USD | Unhedged | Hedged – Static | Active | |
|---|---|---|---|---|
| How currency changes affect the return of: ⭢ | an unhedged portfolio ⭢ | a fully hedged portfolio ⭢ | a 50% hedged portfolio | % varies |
| CAD appreciates 15% against USD | -15% | 0% | -7.5% | Outcome based on portfolio manager decision |
| CAD depreciates 15% against USD | +15% | 0% | +7.5% | |
Implementing a hedging strategy
There are two main ways that portfolio managers hedge foreign currency risk:
1. Forward contracts allow the portfolio manager to lock in a particular exchange rate between two currencies for future transactions. The advantage is that if the portfolio manager buys or sells an investment, he or she doesn’t have to worry about losing a lot of money when it comes to exchanging currencies. On the other hand, the fund won’t benefit if currency fluctuations work in its favour.
2. Options give the holder the right, but not the obligation, to exchange one currency for another at a set rate during a certain period of time, in exchange for a fee.
Currency hedging and your investments
Most iA Clarington funds that invest outside of Canada use currency hedging to some degree. The extent to which the fund is hedged, and the methods used, are determined by individual portfolio managers based on their investment philosophy and the objectives and strategies of the fund. Your advisor can tell you more about whether funds you own employ currency hedging.
Speak with your advisor
If you have questions about currency risk, exchange rates or currency hedging, your advisor can help. Your advisor can also tell you more about how iA Clarington funds manage each of these factors.
For definitions of technical terms in this piece, please visit iaclarington.com/glossary and speak with your investment advisor.
The information provided should not be acted upon without obtaining legal, tax, and investment advice from a licensed professional. Commissions, trailing commissions, management fees, brokerage fees and expenses all may be associated with mutual fund investments, including investments in exchange-traded series of mutual funds. The information presented herein may not encompass all risks associated with mutual funds. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.
The iA Clarington Funds are managed by IA Clarington Investments Inc. iA Clarington and the iA Clarington logo, iA Wealth and the iA Wealth logo, and iA Global Asset Management and the iA Global Asset Management logo are trademarks of Industrial Alliance Insurance and Financial Services Inc. and are used under license.