How currency volatility can impact income portfolios

Market Insights: November 21, 2016 • Currency risk
 

“Because the Canadian market is so concentrated, investors should invest abroad for sufficient diversification. The next issue then is: what should investors do with foreign currency exposure? I consider currency an asset class that needs to be actively managed.”

— Clément Gignac, M.E.Sc
Portfolio Manager, Industrial Alliance Investment Management
Senior Vice-President and Chief Economist, iA Financial Group

“We hedge the majority of our currency exposure in effort to mitigate risk. We feel that this is prudent, particularly in mandates with fixed income exposure, because being wrong on currency could wipe out returns.”

—  Dan Bastasic, MBA, CFA
Senior Vice-President, Investments
iA Clarington Investments
 

Currency risk: A key issue in income investing

Investors seeking income may look beyond Canada in their search for yield. Foreign investments can diversify choice, offering greater access to additional asset classes, higher yields or other opportunities not readily available in Canada. It’s a prudent approach that’s adopted by many investors with an appetite to expand their portfolios beyond domestic markets. While this may bring added diversity and opportunity, it also introduces added complexity through the potential for fluctuation in currency exchange rates.

Generally, when foreign investments are purchased, investors have to change Canadian dollars into the local currency of their investment in order to make the purchase. When the time comes to sell, the sale is made in the foreign currency and then converted into Canadian dollars. The change in the value of the Canadian dollar relative to that of the currency of the foreign investment can either add to or subtract from returns.

For investors seeking to draw income, it is critical to manage the risk of loss due to currency exchange rate fluctuations.

 

Common investment wisdom suggests that over long periods of time, the impact of foreign currency fluctuations may be negligible for investors with a long-term time horizon. However, for investors seeking to draw income, it is critical to manage the risk of loss due to currency exchange rate fluctuations.

This can be demonstrated by examining historical global bond performance using both a hedged (currency exchange rate fluctuations are managed) and an unhedged global bond index for illustration (Chart 1). Over 15 years, the hedged portfolio delivered a 5.1% annualized return, just slightly outperforming the unhedged version, which delivered 4.2%. However, the investor experience would have been quite different, with the unhedged bond index delivering substantially more volatility (standard deviation) over key points in time during the holding period (Chart 2).


Chart 1: Annual returns of hedged vs. unhedged global bonds

Chart

Chart 2: Historic volatility of hedged vs. unhedged global bonds (standard deviation)

Chart

Source (charts 1 & 2): Bloomberg, August 31, 2016. Global bonds – unhedged represented by Barclays Global Aggregate TR CAD, global bonds – hedged represented by Barclays Global Aggregate TR HDG CAD.


When you combine the potential for increased volatility with the need for annual withdrawals, the negative impact that unhedged currency exposure may impose on an income portfolio becomes even more pronounced.

Using the same bond indexes for illustration, consider two hypothetical investors, each with a bond portfolio of $1 million, who plan to make annual inflation-adjusted withdrawals starting at $50,000. Investor A holds a hedged portfolio, while Investor B has an unhedged portfolio (Chart 3). After 15 years of annual withdrawals, the hedged portfolio has a value of $926,000, while the unhedged portfolio is worth only $608,000 – a difference of over $300,000. Faced with the challenge of funding several decades in retirement, managing the risk of currency fluctuation remains a critical need that has the potential to make or break investment outcomes.

Chart 3: Impact of withdrawals on hedged vs. unhedged bond portfolios

Chart

Hypothetical example for illustrative purposes only.
Source: Bloomberg, August 31, 2016. Unhedged portfolio represented by Barclays Global Aggregate TR CAD; hedged portfolio represented by Barclays Global Aggregate TR Hdg CAD. Assumptions: $1M initial investment with annual cash-flow withdrawals of 5% of initial portfolio value adjusted for 2% inflation.

 

Help reduce the risk

Investors seeking the advantages that foreign income investments may offer, while also wishing to minimize the related risk of loss from currency fluctuations, may want to consider an actively managed investment solution. Active mutual fund managers can oversee a strategy of full or partial hedging within the portfolios they manage. Depending on the skill of the managers and the mandate of the fund, they may seek to take advantage of anticipated and favourable currency movements as they arise, or instead they may maintain a full or partial hedge on holdings in an effort to dampen currency risk and focus primarily on security selection and / or asset allocation. The goal in all cases is to optimize the outcome for investors.

 

To help manage currency risk, diversify your clients’ income portfolios through an active solution. Consider:

For more market insights you might be interested in, please visit Market Insights
 

Dealer use only . Statements by the portfolio manager or sub-advisor responsible for the management of the fund’s investment portfolio, as specified in the applicable fund’s prospectus (“portfolio manager”), represent their professional opinion, do not necessarily reflect the views of iA Clarington, and should not be relied upon for any other purpose. Statements that pertain to the future represent the portfolio manager’s current view regarding future events. Actual future events may differ. iA Clarington does not undertake any obligation to update the information provided herein.
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