Clients looking to diversify their portfolios globally are probably taking note of the heightened currency risk created by the strengthening loonie. One answer for these would-be international travellers are new funds that hedge their foreign currency exposure back into the Canadian dollar to reduce or eliminate currency risk.

Whether or not your clients should invest in these funds depends on their personal objectives, risk tolerance and the extent to which they are exposed to foreign markets. Before making any decision, they should have a clear understanding of the benefits and shortcomings of participating in funds described as currency-hedged or currency-neutral.

“It all depends on the risk profile of the investor, how much foreign exposure he or she currently has in the overall portfolio and how that foreign exposure is achieved,” says Adam Felesky, president of Toronto-based BetaPro Management Inc. Felesky cautions that a fund’s currency hedging should not be the most important investment consideration.

“Currency risk is probably the least important factor when investing globally,” he says, adding that performance track record and management strength are more important variables.

In recent months, Mackenzie Financial Services Inc., CI Mutual Funds Inc., RBC Asset Management Inc., Dynamic Funds Management Ltd., Criterion Investments Ltd.and TD Asset Management Inc. — all of Toronto — and Phillips Hager & North Investment Management Ltd. of Vancouver have launched currency-hedged funds aimed at satisfying the needs of a growing number of investors who are looking for portfolio diversification by investing globally but are cautious about taking on the currency risk arising from the rising C$.

“There is a subsegment of the market that is averse to currency risk,” says Timothy Pinnington, president of TD Mutual Funds in Toronto, which launched five currency-neutral funds in September. “These investors want depth of choice across all asset classes and would like to invest globally as if they were investing in Canada.” Investing in currency-neutral funds makes this possible, he adds.

TDAM’s five U.S. currency-neutral funds are directly linked to five existing U.S. equity funds: TD U.S. Blue Chip, TD U.S. Large-Cap Value, TD U.S. Mid-Cap Growth, TD U.S. Small-Cap Equity and TD U.S. Equity Advantage Currency Neutral funds.

Criterion’s three funds include Criterion Global Dividend Currency Hedged Fund, which invests in 30 blue-chip multinational companies; Criterion International Equity Currency Hedged Fund, a variant on an existing U.S. fund; and Criterion Diversified Currency Hedged Fund, which provides exposure to a basket of 19 commodities.

“Traditional global investing introduces currency risk that is rarely articulated,” says Ian McPherson, Criterion’s president. “While it makes sense to invest globally, it doesn’t make sense for Canadians to take on future foreign exchange risk.”

McPherson points out that the recent rise in the C$ introduces a real risk that returns will be negatively affected by multiple exchange rates — a factor that is beyond investors’ control. “The solution is to protect foreign investments by selecting currency-hedged investments that lock in the current Canadian exchange rate,” he adds. “That way, you need only to focus on investment performance.”

The rise in the C$ against the U.S. dollar and other major foreign currencies has had a dramatic impact on the value of investors’ foreign holdings when they are translated into C$. For instance, for the one, three- and five-year periods ended July 31, 2006, the Standard & Poor’s 500 composite index was up 5.4%, 10.8% and 2.8%, respectively, in US$ terms. But when returns are converted to C$, they are much lower — 2.6%, 3.1% and a loss of 3.2%, respectively. The poorer returns received by Canadian investors are directly related to the rise in the C$.

Comparing a fund in both C$ and US$ shows how its rate of return is affected by the rise in the C$ against the US$. For example, Dynamic Power American Growth Fund (US$) had a 2.1% loss for the year ended Aug. 31, 2006, and a 14.6% average annual compound return for the three years ended Aug. 31. In C$ terms, the fund lost 8.93% in one year and returned 6.33% annually over three years.

Since January 2002, the C$ has been propelled by strong commodity prices, gaining more than 40% on the US$ to reach its highest level since 1978 earlier this year. Views on the continuing climb of the loonie are mixed and are directly linked to the ongoing strength of commodity prices. Although some analysts see the C$ reaching parity with the US$ in a couple of years, others are less optimistic, believing that weakening commodity prices will stop its climb. This uncertainty has led to increased caution about currency risk.

@page_break@Currency-neutral funds use derivatives such as forward and futures contracts to hedge exposure to a foreign currency. “Through the use of forwards, we have implemented automatic hedging, which covers our currency exposure each day,” says McPherson, whose company launched its three currency-hedged funds in September.

With the impact of currency fluctuations neutralized, returns of currency-hedged funds are determined by the gain or loss in the securities held by the fund. By hedging currency exposure, investors are assured of getting the actual returns of the global fund. Currency-hedged funds are unlike mutual funds that do not hedge their currency exposure; the latter’s returns are affected by currency changes as well as by portfolio gains or losses. Some funds may only use a partial hedging strategy, exposing the portfolio to both market and currency risk, albeit reduced currency risk.

The drawback to investing in currency-hedged funds is that investors are betting the C$ will either remain flat or continue to rise against major international currencies. If the C$ falls, funds that do not hedge their portfolios could perform better than their hedged counterparts. As a result, views about currency-neutral funds differ.

Don Reed, president and CEO of Franklin Templeton Investments Corp. of Toronto, sees little value in hedging. “The value added [to] hedged portfolios is far less than the cost of hedging over the long term,” he says. “Many studies show that it all comes out in a wash over time, making currency hedging unnecessary in most cases.”

Templeton probably has one of the longest track records in global investing, he says, and although it uses this strategy in some of its funds and is looking at hedged portfolios, it does not see hedging as a key driver in global investing.

Reed argues that many companies that derive their revenue globally already have hedging programs in place. By implementing a hedging strategy, he says, “You are essentially hedging the hedgers.”

McPherson, however, believes that although currency differentials even out over the long run, this is not relevant to the average investor who is unlikely to wait 20 to 25 years for the “cycle to wash out.” He adds: “Investors are not compensated for the risk they take if it’s a wash in the long run.”

Pinnington, however, says the only risk to a currency-neutral strategy is “leaving potential upside risk on the table” if the C$ falls relative to other major currencies.

There’s a price to participate in a currency-hedged fund. The cost of hedging can be as high as 1% for a multi-currency fund, which is absorbed by fund, lowering returns. Funds that hedge only the US$ charge less — about 15 basis points, McPherson says.

Despite the pros and cons, demand for currency-hedged funds is coming directly from investors. Simon Hitzig, executive vice president of Dynamic in Toronto, says the launch of the US$ version of Dynamic Power American Growth Fund is in response to demand from advisors on behalf of clients. Pinnington and McPherson agree.

Given that views about the di-rection of the C$ diverge widely, it at least may be prudent to consider reducing currency risk when investing globally. IE