Currency Risk

Question: I do not understand our poor returns on our American investments, considering we see big gains on the Dow Jones Index.

Answer: Your assessment is correct. The Standard & Poor's 500 stock index was up to 4.2 per cent and NASDAQ advanced 9.6 per cent at the end of spring 2003, and yet the average U.S. equity funds had a negative 4.6 per cent return.
Here's why.

Changes in Canadian currency affects the U.S. Funds performance

One of the risks associated with international investments is currency risk. The currency risk, also called exchange rate risk, can affect individual investors who have or who are considering international investments.

The risk is that the investment value will be affected by changes in the exchange rate. For example, if money must be converted into a U.S. currency to make an investment in U.S. holdings, changes in the value of the Canadian currency, relative to the American dollar, will affect the total loss or gain on the investment when the money is converted back to Canadian dollars. Currency risk can be beneficial or detrimental to the investment value.

We also know the S&P 500's 4.2 per cent U.S. dollar gain represents a decline of over 4 per cent when translated into Canadian dollars. How does this happen?

The Canadian dollar has gone up in value from 63.87 cents at the beginning of the year to 69.764 cents at the end of April 2003 (most recently, the Canadian dollar has broken the 74 cents mark, and now descending again). In just four months, the Canadian dollar has appreciated by over 10 per cent versus the U.S. dollar.

For investors who own U.S. equity funds in Canadian dollar denomination, the rise of the Canadian dollar meant its value relative to the U.S. dollar has wiped out any market gain.

For example, an individual invested $10,000 into U.S. equity funds at the beginning of the year when the dollar was at 63.387 cents. The fund manager then purchased $6338.70 of U.S. stocks. By the end of April, the U.S. stocks appreciated to $6650 and the Canadian dollar rose to 69.764 cents. If the investor decided to cash out, the proceeds would be $9,532 after converting to the Canadian dollar.

While the investor's U.S. portfolio appreciated 4.9 per cent, the return on the $10,000 Canadian dollar investment was negative 4.68 per cent.

What does this mean to investors? Where should they invest now? How much should be invested in foreign markets?

Predicting the direction of the currency is impossible. The best thing for investors to do is to maintain a diversified portfolio and include some global diversification. While the world economies are more closely tied than ever before, there are still circumstances causing some countries to be in favour with investors and some to be out of favour. These rotations in preference, particularly when combined with the strategies of dollar cost averaging and diversification can lead to growth and wealth accumulation in the long run. The amount of foreign content in the portfolio depends on the individual investor's risk tolerance and investing time horizon.

Remember, how a portfolio fares in the market has less to do with what the dollar does, or even what the economy does, and more to do with what you do to stay on track with your financial security plan.

The information contained in this article is intended to provide general guidelines only. The material herein is provided solely for informational and educational purposes and is not to be considered as an offer or solicitation for the sale or purchase of any investments or insurance. The application and impact of the law can vary from case to case based on the specific or unique facts involved. Accordingly, the information in this article is not intended to serve as legal, accounting or tax advice. Users are encouraged to consult with their professional advisors for advice concerning specific matters before making a decision.