In the face of a strengthening Canadian dollar, mutual funds holding global or U.S. funds with a policy of currency hedging have experienced a significant performance advantage in the past few years compared with their unhedged brethren.

That has persuaded a number of firms, including Mackenzie Financial Services Inc., CI Mutual Funds Inc. and RBC Asset Management Inc. , all of Toronto, to introduce new global or U.S. funds designed to hedge exposure to foreign currencies. In addition, many are allowing international fund managers the flexibility to hedge their portfolios, fully or partially, when they see fit.

The C$’s rise relative to other currencies, such as the U.S. dollar, has been dramatic in recent years. And that has hurt the value of Canadians’ international investments after returns are translated into Canadian currency.

Hedging offers investors the opportunity to protect themselves from currency fluctuations. As the number of funds employing hedging strategies increases, investors are presented with a new dimension to their investment decisions. They now may decide how much hedging they want in their portfolios, and can also mix some fully or partially hedged funds with those that are exposed to exchange rate moves.

“Funds employing hedging strategies offer an extra tool that advisors can use to help clients with portfolio diversification and financial planning,” says David Feather, president of Mackenzie Financial. “It’s not a matter of currency speculation; it’s a matter of deciding the appropriate level of exposure to investments denominated in foreign currencies. Hedging is used as a risk-reduction strategy.”

However, there is a cost to this type of insurance, and hedging could actually take away from returns if the C$’s climb comes to an end. In addition, history shows that exchange rate differentials tend to balance out over periods of more than 10 years, particularly in globally diversified portfolios with exposure to several currencies.

Still, in the past three years, the C$ has risen more than 20% against both the US$ and the Japanese yen, and slightly less against the euro. From the CS’s trough four years ago to its peak, it has risen more than 35% against the greenback.

Although it is hard to argue with the logic of international diversification, the dent on returns as a result of the rising C$ may be creating a disincentive to venturing outside of the domestic market. But Canada doesn’t offer a lot of investment opportunity in certain industries, including pharmaceuticals, entertainment companies and consumer stocks; roaming the world provides far broader choice.

International investing also provides exposure to emerging markets, or to countries offering more diversified opportunities or better valuations than the resources-oriented Canadian markets.

By using derivatives such as managed futures and currency forward contracts, fund managers can insure or “hedge” portfolios against the effects of fluctuating currencies. However, if the C$ falls instead of rises, the cost of hedging would be wasted. An international portfolio owned by Canadian investors with no hedge would be positively affected by a sinking C$.

In March, Mackenzie Financial created currency-hedged versions of two existing funds — Mackenzie Universal American Growth Capital Class and Mackenzie U.S. Growth Leaders Capital Class. These hedged funds give Canadians the choice of investing in U.S. equity funds without being affected either negatively or positively by fluctuations in the exchange rate between the Canadian and U.S. currencies.

“Canadian investors have watched our dollar rise strongly against the U.S. currency in the past few years,” Feather says. “If they’ve been invested in unhedged U.S. equities, they may have received a diminished return — even if the stocks went up.”

Although the two new funds will make it a policy always to be hedged against currency fluctuations, many other funds in the Mackenzie stable hedge when it suits the individual manager.

The international Mackenzie Cundill Value Fund, for example, makes it a regular practice to hedge against fluctuations in exchange rates between the loonie and international currencies such as the US$ and the yen. As a result, the fund’s returns are solely based on investment selection. This policy helped the fund’s returns relative to many of its peers in the past four years when the C$ has risen.

However, when the loonie was weakening during the 1990s, Mackenzie Cundill Value Fund reaped no benefit from the hedge, while unhedged international funds got a boost from currency moves.

@page_break@According to figures from Morningstar Canada, the median international equity fund showed a 2.7% average annual return for the four years ended March 31, while the median Canadian equity fund chalked up 9% for the same period. The international category includes funds that don’t hedge at all, as well as those that hedge to varying degrees. The hedged Mackenzie Cundill Value Fund made a 9.4% return in the same period.

Templeton Growth Fund, from Toronto-based Franklin Templeton Investments Corp. , also canvasses the world in search of the best opportunities. It produced an average annual return of 1.7% during the same period for C$ investors. However, the US$-denominated version of the fund — which is available to Canadians but is reported in US$ and is therefore unaffected by changes in the value of the C$ — made 9.9%.

Don Reed, president of Franklin Templeton, says the company does not hedge in its Templeton-branded international equity funds as this does not pay off in the long term. Hedging strategies are employed at Franklin Templeton on the global fixed-income side, however, because currencies can sometimes create more volatility than fluctuating bond prices. Hedging strategies are also used in some of Franklin Templeton’s affiliated Mutual family of equity funds.

“Periodically, we study hedging and the impact on investors in various countries,” says Reed. “During the past 10 years, including two business cycles, with the added cost of hedging, there would have been no pickup for North American equity investors.”

Reed says the cost of hedging the many foreign currencies in Templeton equity funds could add up to as much as 1% of a fund’s net asset value. He adds that many multinational companies already have internal hedging programs in place, particularly if they rely on a component or a commodity that is priced in a foreign currency, so there is no point “hedging the hedge.” Or such firms may have built-in hedges if they are borrowing in various countries and paying back the loans in local currency.

David O’Leary, senior analyst at Morningstar Canada, agrees that over long periods of more than 10 years, currency differentials between the C$ and US$ have historically evened out. But over shorter time horizons, there can be significant risk and increased volatility associated with unhedged portfolios.

“While currency fluctuations may be a wash in the long run, they can make a huge difference for investors with three- or four-year horizons,” says O’Leary. “Most investors won’t stay in a fund long enough to make it a wash. Hedged funds are a valuable addition to the investment fund product line.”

He says hedging makes the most sense when the fund portfolio is exposed to just one international currency, such as the US$ or the yen, rather than a basket of diversified global securities that could move in different directions and offset one another.

David Fingold, associate portfolio manager at Toronto-based Dynamic Mutual Funds Ltd. and manager of a handful of international value-style equity funds, says he assesses the currency risk every time he adds a holding to a fund and, unless he expects the currency in the country in which the investee company is based to rise, he will hedge his exposure. He says he is not making “top-down” currency calls, but rather trying to control risk by neutralizing the effects of currency swings.

The cost of hedging can be easily covered by the dividend yield on his funds, he says.

“You cannot separate the country risk from the equity exposure,” he says. “I won’t buy a company unless I think it is going to add to the return of the portfolio, and currency risk is one of the considerations. If I can take that risk off the table, I will. On the other hand, if I see fundamental reasons for an improvement in the foreign currency, I am prepared to be exposed on a long-term basis.”

RBC Asset Management generally hedges in global bond portfolios to remove the impact of currency movements on investment returns, and will sometimes make a top-down decision to hedge its U.S equity funds. RBC O’Shaughnessy funds with U.S. holdings consistently use currency hedging strategies so the returns earned by Canadian investors match those earned by U.S. investors in the same portfolio. In January, RBCAM introduced hedged versions of its two core U.S. equity funds. The new funds are RBC U.S. Equity Currency Neutral and RBC U.S. Mid-Cap Currency Neutral, and they will always be hedged against currency movements.

“A number of investors are concerned about the impact of currency moves,” says Michael Higgins, senior manager of investment communications at RBCAM. “Many people are entering retirement, and a large swing in the currency in the first year or two of retirement could impact a portfolio to the point at which it would affect investors’ retirement planning.”

Difficult to predict

CI Select International and CI Select U.S. mixed-fund equity pools, introduced in January, are hedging 50% of their assets against currency fluctuations. William Sterling, chief investment officer of New York-based Trilogy Advisors LLC and subadvisor to CI, says that although hedging offers protection, predicting the direction of currencies is difficult to do. The waters can be clouded by the circumstances that often go along with a weak currency, such as rising interest rates or exporting advantages for companies.

“The financial derivatives used to hedge are like razor blades,” he says. “Razor blades can be used to perform brain surgery or commit suicide. Fund managers who are using hedging strategies need to ask themselves two questions: if I am right, what will happen; and if I am wrong, what will happen. Currencies can be fickle, and hedging is best used as a risk-budgeting strategy.”

In addition to actively managed hedged portfolios, investors can choose from a couple of exchange-traded funds offering hedged exposure to U.S. and international stocks — Barclays iUnits S&P 500 C$ Index Fund and iUnits International Equity C$ Index Fund, the latter of which tracks the Europe/ Australia/Far East index.

Higgins says that, although currency risk has always existed, until the past four or five years it has not affected Canadian investors in a negative way. Now that the C$ has seen a few years of strength, there is more awareness of the impact of currency movements. As investors become more educated, currency exposure is something they will be discussing with their advisors. IE