While geographic diversification is always vital, foreign investments result in foreign currency exposure, which can be a source of both risk and opportunity. Therefore, it’s essential to have the right currency management strategy in place.
Currency risk (or “exchange-rate risk”) exists because foreign investments are priced in foreign currencies. When the foreign currency in question appreciates or depreciates against the Canadian dollar, the total return of the foreign investment is impacted.
Using proven professionals can actively manage currency risk
To most effectively mitigate currency risk and add returns from investments outside of Canada, portfolios should integrate a sound process, preferably driven by an “active management strategy” that considers all known risks, and employs robust analytical research and forecasting.
For example, MD works with currency experts at CIBC Asset Management who have a long track record of managing currencies. They use a rigid investment process, guided by a powerful quantitative model and supported by professional judgment and analysis. This represents a dynamic active currency management program for MD funds that manages over 30 currencies on a daily basis.
Currency hedging: Reducing exchange-rate volatility
Through an intelligent decision framework, a professional financial provider can determine how and when “currency hedging” should take place. Currency hedging consists of taking an offsetting position in a related security in order to reduce or eliminate a risk. Investing in international securities may result in volatility when currency rates change and the value of the investment is calculated in a local currency. Currency hedging reduces the volatility that results from exchange-rate changes.
Through active management, the currency manager increases or decreases the foreign currency exposure depending on the view toward the currency. This is a significant advantage over a fully hedged passive strategy, as it offers investors an opportunity to enhance returns and profit from the movements in currency.
Comparing hedging strategies
Here’s a look at the most common currency hedging strategies:
- Passive hedging. With a passive currency overlay strategy, all foreign currency exposure is hedged back to the Canadian dollar.
- Pure alpha. With a pure alpha strategy, currency risk is separated from the underlying portfolio and excess return (“alpha”) is generated by actively taking currency exposures.
- Dynamic currency management. An active currency management strategy allows more flexibility in how and when currency decisions take place.
A dynamic currency management approach, like the one used by MD, has the flexibility to provide effective management of many currencies—not simply the U.S. dollar, Canada’s traditional benchmark—and can be applied to all investments that have foreign components. We believe that this is one of the most effective approaches over the long run when it comes to managing currency risk and potentially enhancing your returns.