The strong move upward in the Canadian dollar may have clients asking about foreign currency hedging. Hedging can make a lot of sense when it comes to protecting investments, but this may not be the best time to adopt the strategy, experts say. Few think the C$ will continue its climb over the next year.

“I would argue that now is not the time to be worried,” says Todd Asman, vice president of strategic investment planning at Investors Group Inc. in Winnipeg.

He admits that may not be an easy sell to clients. “Investors get caught up in the emotions of what has happened lately — in this case, the dramatic rise in the C$ vs the U.S. dollar, from the low US60¢ range to above parity,” he says. “This leaves them feeling they don’t want to be in the U.S.”

However, of the economists at the Big Six banking groups, only CIBC World Markets Inc. in Toronto expects the loonie to climb further — and then by not much. It pegs the value of the C$ at US$1.05 by the end of 2008. In contrast, Royal Bank of Canada expects the C$ to be at US93.5¢ at 2008 yearend,
TD Bank Financial Group at US95¢, BMO Nesbitt Burns Inc. at US96.8¢. Both Bank of Nova Scotia and National Bank Financial Ltd. think it will be around parity.

Many investment managers agree the C$ is not on a sustainable upward trajectory. For example, Bill Sterling, chief investment officer at Trilogy Advisors LLC in New York, which manages a number of funds for Toronto-based CI Investments Inc. , says that a C$ much more than US80¢ is overvalued given Canadian costs and economic fundamentals.

Their rationale for a lower C$ is slowing U.S. and global growth, which is expected to moderate resources prices and, thus, take the momentum out of the soaring loonie. Only CIBC World Markets expects oil prices to remain near recent levels, forecasting an average price of US$90 a barrel in 2008.

There are other, more general reasons for steering clear of hedging:

> Staying unhedged gives you the opportunity to offset some of the losses you had when the C$ was going up.

> Currency movements tend to wash out over time. A lot of mutual fund suppliers believe investors are better off focusing investment choices on a well-diversified portfolio and picking good managers.

> There is much less choice if you want to buy a hedged foreign equity fund and it’s expensive to buy separate hedges.

That said, some foreign equity funds employ hedging as part of their investment strategies. And there are experts who favour hedging despite the current climate.

Funds managed by Mackenzie Cundill Investment Management Ltd. in Toronto and James O’Shaughnessy at New York-based Bear Stearns Asset Management Inc. for RBC Asset Management Inc. use hedging. Both funds believe in their ability to get good returns through stock picking and asset allocation, and don’t want currency movements confusing their track records.

WINNING TEAMS

Both management teams have done well over the past several years. There are six Mackenzie Cundill foreign mutual funds and all but Mackenzie Cundill Global Dividend Fund have had first quartile calendar year returns since 2001, according to Morningstar Canada data. Although this was partly the result of the negative impact of the rising C$ on competitors’ unhedged funds in 2003-07, that was not a factor in 2001 or 2002.

RBC O’Shaughnessy U.S. Value Fund has been a first-quartile performer since 2000, while RBC O’Shaughnessy U.S. Growth was second quartile in 2001 and first quartile thereafter.

Both Mackenzie and RBCAM have introduced C$-hedged versions of other foreign equity funds in the past few years, to give investors more choice. Currency neutral versions of RBC U.S. Equity Fund and RBC U.S. Mid-Cap Equity Fund were introduced in January 2006. RBC has had a hedged version of its U.S. index fund since 1998.

Mackenzie has hedged versions of Mackenzie Ivy Foreign Equity, Mackenzie Universal American Growth, Mackenzie Universal U.S. Dividend Income and Universal U.S. Growth. Mackenzie also has a hedged version of Mackenzie Canadian Ivy because Mackenzie managers have the option of including up to 49% foreign content in Canadian equity funds.

The fact that Canadian funds can include foreign equities has to be factored into the decision about whether and how much to hedge. Of the 654 Canadian equity funds for which Morningstar had holdings data as of Sept. 30, 191 had less than 70% Canadian exposure. These numbers include various versions of the same funds so there is double-counting but that shouldn’t change the fundamental picture.

@page_break@Advisors also need to consider that some foreign funds have significant amounts of Canadian equity — there were 53 of 970 foreign funds with 30% or more Canadian exposure.

And many companies, both Canadian and foreign, have exposure to other currencies. This applies to all resources companies because resources are priced globally in US$s. It also applies to industrial companies, many of whose products are also priced in US$s. And it applies to all companies that export goods and services because revenues will be in the currencies of the countries in which they sell; revenue then has to be translated into the currency in which the company reports.

A supporter of hedging, Ian McPherson, president of Criterion Investments Ltd. , a division of VenGrowth Asset Management Inc. in Toronto, believes Canadian investors should consider currency hedging unless they have a 20- year time-frame. It takes that long for currency gains and losses to wash each other out, he says. The typical retail investor has a three-year time frame.

Criterion was created in 2006 to provide a family of currency-hedged mutual funds. There initially were three funds — global dividend, international equity and diversified commodities, all launched in May and June of that year. Criterion Water Infrastructure was introduced in February 2007 and Criterion Clean Energy Fund in September. The latter two funds both have hedged and unhedged versions.

McPherson is not suggesting that clients be fully hedged but he does suggest significant currency hedging. He recommends either hedging 50% of foreign currency or asking clients what they think the odds are that the C$ will be higher a year from now. If they say 70%, suggest hedging 70%; if it’s 25%, go with less hedging.

Hedging proponents note that forecasting exchange rates is a very iffy business. No one expected the C$ to go up 40% vs the US$ over the past five years. And every time it goes up, U.S. equity returns are lowered in C$ terms. So, although many experts say the C$ will decline in value by 2008, investors can take this with a grain of salt.

Hedging boosters also note investors shouldn’t count on fund managers to neutralize the impact of currency fluctuations. In general, fund managers are not currency experts, so clients may want to buy some currency protection.

Exchange rate movements can have a big impact on income generated in a portfolio. If clients see income dip because of a climbing C$, they may not have the money to meet expenses. This is less of an issue when clients are saving for retirement, because returns are generally reinvested. But if currency changes are large and continue for a considerable period of time, as with the 40% rise in the loonie vs the US$ since 2002, it can affect how much assets and income clients have in retirement. IE