The soaring value of the Canadian dollar relative to the U.S. greenback in the past few months has brought the C$ close to parity with the US$, which has had a negative impact on Canadians’ international investment portfolios. However, a growing number of investment fund companies are offering products that use hedging strategies to neutralize currency fluctuations.

A rising C$ erodes the value of investment gains made in international markets once those gains have been converted back into our home currency for Canadian investors. Conversely, when foreign currencies — such as the US$ — are ascending against the loonie, those gains enhance the returns made in international markets for Canadian-based investors.

Although many managers of regular international mutual funds have the liberty to hedge strategically to protect or enhance their returns, “currency-neutral” funds are designed to immunize fund portfolios against exchange rate fluctuations, be they negative or positive.

Invesco Trimark Ltd. and Fi-del-ity Investments Canada Ltd. have broadened their lineup of currency-neutral funds recently, due to investor and advisor demand. Also offering currency-neutral fund products are TD Asset Management Inc., Mackenzie Financial Services Inc., Criterion Investments Inc.and RBC Asset Management Inc. And currency-neutral versions of U.S. and international exchange-traded funds are offered by Barclays Global Investors Canada Ltd. and Claymore Securities Inc. (All named companies are based in Toronto).

“Currency volatility has been far beyond normal during the past few years,” says Jonathan Hartman, vice president of investment products with RBCAM. “There is room for a mix of hedged and non-hedged products, depending on an inves-tor’s time horizon and view of currency risk.”

Fluctuating currencies can have a major impact on investment returns. For example, for the 10 years ended Sept. 30, the S&P 500 composite index showed an average annual loss of 0.15% in US$. But for investors using C$, the index’s performance worsened to show an average annual loss of 3.25% for the 10-year period. For shorter time frames, the currency effect can be even more extreme. For the three months ended Sept. 30, the S&P 500 rose by 15.6%. But because of the rapidly ascending C$ during this period, Canadian investors in the S&P 500 made only 6.6%.

“Currency movements are a big issue and, in some cases, have created an investor aversion to foreign equities,” says Rudy Luukko, investment funds editor with Morningstar Canada in Toronto. “Given that Canada accounts for less than 5% of world investment opportunities, there is a benefit to diversifying internationally, and currency-neutral funds allow investors to achieve that diversification without being affected by either currency gains or losses. ”

Studies show that currency movements in international markets historically have balanced out over periods of 15 years or more for Canadian investors. However, the average holding period for mutual funds is typically less than three years, and currency volatility in the short-term can be nerve-wracking.

Currency-neutral funds make sense for those investors with short time horizons, such as clients at or near retirement or those who plan to cash out their funds to finance education or some other large expenditure. These funds also make sense for those who are drawing an income from their international funds in C$.

But these funds are not for those who want to speculate on exchange rate movements at certain times, as they will receive no benefit from a declining Canadian currency.

Overall, a rising C$ has negatively impacted unhedged Canadian investors holding US$-denominated investments since late 2002, when a pathetically weak C$ ended the year near a low point of about US63¢. But the opposite effect had occurred through the previous decade, as the US$ increased in value relative to the loonie during the 1990s, adding extra sizzle to international portfolios held by Canadians.

“Currency movements are like the wind — sometimes it’s a headwind and sometimes it’s a tailwind,” says Ian McPherson, president of Criterion, whose entire fund family is available in both hedged and unhedged versions. “Currency hedging can eliminate the wind. It’s a benefit to investors who don’t like the roller-coaster ride; to take the wind out of the equation. Movement in currencies can be comparable in scope to equities market moves, so it’s an important risk factor, and one that can be mitigated with currency-hedged funds.”

@page_break@As the number of funds employing hedging strategies increases, advisors and their clients are presented with a new dimension to their investment decisions. They may decide when and how much to hedge, or they may also mix some fully or partially hedged funds with those that are exposed to exchange rate moves.

Exposure to foreign currencies is not always a bad thing, and there are times when it can be beneficial and provide additional diversification. Those investors who plan to retire in the U.S. may want US$ exposure, for example. And with the C$ close to parity with the greenback, there may be less need to hedge than when the loonie was worth US63¢.

“The loonie may well continue in the same direction, but be careful,” says Adrian Mastracci, portfolio manager with KCM Wealth Man-agement Inc. in Vancouver. “Currencies can retrace just as fast or faster than they advance.”

Among the new offerings, Invesco Trimark has just launched 11 Series H currency-neutral versions of its popular foreign equity funds, including Trimark Select Growth Fund, Trimark Fund and Trimark Global Endeavor fund, Aim Global Growth Fund, as well as of balanced funds Trimark Global Balanced Fund and Aim Global Balanced Fund. Five of the funds are in the firm’s corporate-class family, which enables investors to switch among funds without triggering capital gains.

For clients who want to benefit from a fund manager’s expertise in stock selection but want to reduce the currency exposure in their portfolios, the Series H funds offer the same portfolios as the original funds but without the currency effect. Invesco Trimark also offers currency-hedged versions of three private pools and four of its multi-fund Retirement Payout Portfolios.

“We are building our suite of options to give investors the choice of whether they want to negate the currency impact,” says John Ciampaglia, senior vice president of product development with Invesco Trimark. “People are becoming more conscious of the contribution of currency movements to risk, and some are better served by taking that risk off the table.”

Mackenzie Financial offers a series of funds in both hedged and unhedged versions, including Ivy Canadian Fund, Ivy Foreign Fund, Universal American Growth Fund, Universal U.S. Dividend Income Fund and Universal U.S. Growth Leaders Fund. Although Ivy Canadian Fund is not officially a foreign fund, explains David Feather, the company’s president, its 40% foreign content is hedged in the currency-neutral version.

“Using currency-neutral funds is a risk-reduction strategy,” says Feather. “The price that you potentially pay is forgone gain if the Canadian dollar weakens. But, for many people, a forgone gain is preferable to suffering actual exchange rate losses if the currency goes the other way.”

Fidelity first introduced currency-neutral products three years ago in its fixed-income funds, Fidelity Global Bond Fund and Fidelity American High Yield Fund. For investors receiving income, it is important to be able to rely on a predetermined amount, explains Darren Farkas, Fidelity’s vice president of product solutions, and not to have their income stream eroded by exchange rate movements.

Recently, Fidelity launched eight currency-neutral products on the equities side, five pools within Fidelity’s private-investor program and three foreign equity funds within its corporate-class structure (which allows for tax-deferred switching between funds). Farkas says there has been keen interest in the new products, with $20 million in sales in the first two weeks. IE