Managing the risk and opportunity of foreign currencies

The benefits of having a geographically diverse portfolio are well-known: more investment choice, reduced exposure to a single economic region, potential for improved returns, and less risk relative to a less-diversified portfolio. However, foreign investments introduce foreign currency exposures, which can be a source of opportunity and risk.

Consider this example:

Canadian investor owns shares in ABC Company which is traded in U.S. dollars and on the U.S. stock exchange.

Foreign currency risk (AKA currency risk, exchange rate risk, FX risk) exists because foreign investments are priced in foreign currencies. For a Canadian investor, the total return of a foreign investment is impacted by the value of the foreign currency the investment is priced in relative to the Canadian dollar. As illustrated above, it’s prudent to have the right currency management strategy in place.

Removing the risk (and opportunity) of foreign currencies isn’t ideal

Some argue that hedging or removing foreign currency risk is the way to go. On the surface, you are accepting scenario 1 and giving up on the possibility of scenario 2 to reduce risk (to avoid scenario 3). However, hedging foreign currency risk does not necessarily reduce the overall risk of an equity portfolio. 

In fact, the data suggests that the volatility of an unhedged foreign equity portfolio translated back to Canadian dollars is less than the volatility experienced by a comparable hedged portfolio. Why is this the case? The answer is tied to the makeup of our economy and the behavior of our currency.

Given that the Canadian economy is commodity-based, the Canadian dollar is procyclical (tied to economic fluctuations) in nature. Typically, during periods of increased volatility (particularly those grounded in economic slowdowns), commodity prices trend downward. Relatedly, the Canadian dollar also tends to weaken, bolstering the returns of foreign investments when translated back to the Canadian dollar (as illustrated in scenario 2) and thus reducing volatility.

As it could increase the overall volatility in an equity portfolio, it is not ideal to hedge foreign currency exposure absolutely without discretion. As a Canadian investor, the additional diversification that foreign currencies provide is an attractive opportunity.

Consider the total portfolio impact

In a well-diversified, multi-geography portfolio, it’s important to understand that there are many different currencies that all behave differently. In our active, multi-currency equity portfolios, we have more than 30 different currencies resulting from our various equity positions. Given our active approach, the weighting in each of these currencies will often be different relative to the respective benchmarks for each fund.

Some of these currencies have a relationship with overall risky assets, like equities. This is especially true for procyclical currencies, like emerging market currencies and the currencies of commodity-dependent economies. Other currencies are considered safe-haven currencies like the Japanese yen, Swiss franc and the U.S. dollar.

Beyond general relationships with financial risk, certain stock markets can be quite sensitive to fluctuations in the local currency. For example, Japanese equities are strongly negatively correlated with the yen. Generally, a stronger yen leads to weaker equities and vice-versa. This means Japanese equities tend to be more volatile on a hedged versus unhedged basis since the yen and local stock returns are negatively correlated. Similar to the Canadian dollar situation, hedging an active weight to the yen can introduce more risk to an active Japanese equity position.

On the flip side, the Brazilian real (both an emerging market currency and one that is highly linked to commodities) exhibits the opposite characteristics. Generally, the real has a positive correlation with local Brazilian equities. During periods of economic stress, commodities come under pressure and investors seek to de-risk away from emerging markets, leading to pressure on both equities and the currency. In this case, hedging the real results in a reduction of volatility versus leaving it unhedged.

However, this is not to say that one should hedge or stay unhedged any given currency statically as a rule. There are other factors at play (some of which we discuss in the next section). As such, to effectively manage multiple currencies, it is important to understand each currency’s interaction with your total portfolio to ensure the best improvement in risk-adjusted return. To this point we have talked about foreign currency risk, its impact on returns, and why it doesn’t make sense to passively hedge foreign currency exposures indiscriminately.

By incorporating a forward-looking ranking on currencies to get a sense of what currencies are more likely to appreciate or depreciate against the Canadian dollar or other currencies in the portfolio, we can evaluate how foreign currency risk impacts our total portfolio risk. With these ranks, we are able to create a dynamic currency management process that should have a positive impact on risk-adjusted returns relative to passively hedged portfolios or doing nothing at all.

Managing the risk and opportunity 

At MD, we have established currency outlooks and rankings as part of the portfolio management process for all of our funds and pools with foreign equity holdings to actively manage the risk and opportunity of currencies.

Like other asset classes such as bonds and equities, there are strategies that can add value over time. Here are some examples of factors used to manage currencies:

MD’s total portfolio risk management processes allows us to easily identify what currency exposures in our foreign equity positions are diversifying risk or adding to risk. We can then combine this total portfolio understanding of how various currencies impact our risk profile, with forward looking rankings on currencies to determine which currencies are at greater risk of appreciation or depreciation.

This allows us to craft a dynamic, total portfolio currency management strategy that can add incremental value, while also controlling and managing overall risk.

For more information about MD investments or your portfolio, please contact your MD Advisor*.

* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).

The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.