Diversification is a cornerstone of building an investment portfolio. Investors who want to be truly diversified in order to reduce volatility and smooth out returns over time should consider the benefits of global investing.
Many investors focus their diversification efforts only on investing in different asset classes, such as fixed income and equities, or different sectors, such as financial companies and commodities.
Another important key diversification strategy is to invest in companies based in other countries, as the world’s markets do not move in tandem. With Canada’s markets representing less than 5% of the global economy, investing in foreign markets can allow investors to access additional opportunities. Yet, in addition to the opportunities global investing brings, it can also bring along additional risks, one of which is currency risk.
When investing in mutual funds that hold securities denominated in a currency other than Canadian dollars, such as U.S. stocks, this foreign currency exposure becomes an additional risk factor. Your portfolio will not only be affected by changes in the price of the stock or bond, but by exchange rates. If the Canadian dollar declines, this can add to the returns of mutual funds that invest in foreign markets. However, when the Canadian dollar climbs against other foreign currencies, the value of investments denominated in other currencies declines.
For example, if your foreign investment generated an 8% rate of return in one year but the Canadian dollar gained 8% of its value during the same period, your net return would be zero, as you need to convert the sales proceeds back to Canadian dollars.
Many investors may be uncertain about how currency movements can affect their returns and what can be done to reduce risk and protect their portfolios against increased volatility.
If investors are uncertain, they can invest in mutual funds run by portfolio managers who use sophisticated currency risk management strategies. One strategy is called hedging. Hedging is when a portfolio manager locks in the exchange rate and then converts everything back to Canadian dollars at a predetermined, fixed rate. Consider this example: if a U.S. stock is purchased, the stock would be converted at a specific rate back to Canadian dollars so that any fluctuation of the U.S. dollar against the Canadian dollar (while you owned this stock) would not affect the value of your portfolio. For investors, hedging can reduce the uncertainty that comes with currency fluctuations.
Hedging is not always necessary; some currency exposure can be beneficial as it enhances diversification within the portfolio. If the portfolio manager expects certain foreign currencies to perform well against the Canadian dollar, they may choose to keep the stocks denominated in that currency and benefit from any appreciation. Another strategy used by portfolio managers with currency expertise is directly investing in a certain currency that they believe is going to increase in value, therefore benefiting the portfolio as a whole (portfolio managers call this a ‘currency overlay’).
As more and more investors seek the diversification benefits of investing a portion of their portfolio in global assets, they need to be aware of the additional risks involved.
Exchange rate movements impact your foreign investments
Source: AGF Investment Operations as of February 29, 2016.
Talk to your financial advisor about how to manage the unique risks and opportunities of global investing and visit AGF.com/GoGlobal.
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Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in share and/or unit value and reinvestment of all dividends and/or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed; their values change frequently and past performance may not be repeated.