Dollar days
What investors need to know about investing using U.S. currency
Default approach (is) to invest in currency of your home country
One question that seems to be universally on the minds of Canadian investors is, “How much of my portfolio should I invest in Canadian versus American dollars?”
This isn’t surprising for two reasons. First, many Canadians spend a fair amount of time down south, so they are acutely aware of how expensive the U.S. dollar can become from time to time. And second, CAD/USD exchange rates are so consistently volatile that they always seem to be in the news and, therefore, at the top of investors’ minds.
I answer the question with another question: “How much of your annual income, expressed as a percentage, do you expect to spend in USD in an average year?”
The reason that I start here is that for Canadians who spend a great deal of time and money in the U.S. every year, investing part of their portfolio in USD-priced assets isn’t so much investing as much as it is hedging.
If they are able to derive income from their USD investments that roughly covers their USD expenditures, they can become blasé about periodic shifts in the relative value of the two currencies.
For investors who don’t spend a great deal of time or money in the U.S., the answer to how much USD investing they should consider taking on is more complicated.
As a general rule, the default approach should be to invest in the currency of your home country. In Canada, this can be done by either investing in Canadian securities or in foreign currencies priced in CAD (which includes a number of exchange-traded funds that provide exposure to foreign markets, including the U.S., priced in CAD).
This avoids the unintended overlay in your investing of foreign exchange fluctuation — a macroeconomic factor that may have nothing to do with your investment, but can have a huge impact on it.
Think of a fly in a bus. If the bus is travelling eastbound from Toronto to Montreal, does it really matter whether the fly is flying east or west? Similarly, if CAD/USD is moving in increments of 10-20 per cent over relatively short time periods, does it really matter whether the investment makes four or five per cent? Not really.
The success or failure of investments you make in USD can often depend much more on the direction the bus driver decides to go rather than the direction the fly decides to fly.
The one downside to investing in CAD-denominated investments is that sometimes a really solid investment is available only in USD. In this case, you have two options.
The first is to buy the investment naked in USD, knowing that you are making two bets: that the investment will work out and that the CAD will not strengthen against the USD.
The good news is that the USD, as the world’s reserve currency, tends to do very well relative to all other currencies when there is flux in the global economy. If GDP falls in Europe, China or Canada (or even the U.S.), your USD investment might go down in nominal value, but might do just fine when converted back to CAD.
The second option involves hedging your currency risk. If you have a sizable USD-priced portfolio, you can hedge the currency risk using currency forwards. This is less complicated than it sounds, but, as with the preparation of sashimi, is best left to professionals.
If you hedge your exposure in this fashion, the net effect (albeit at a cost, which can be high for smaller accounts) is the same as having invested in CAD in the first place. Of course, you can count on a huge increase in the price of the USD immediately after placing your hedge, Murphy’s Law being what it is.
A final thought. As the breadth of your analysis increases, so does the number of factors that will determine if your conclusions are right, decreasing the chances that you will be.
Picking an individual stock using fundamental analysis is relatively straightforward. Choosing to invest in an entire market involves a calculus that includes many moving parts across many sectors, with the added uncertainty of central bank interventionist activity. And choosing to invest based on the direction of the world economy requires prescience that many claim to have and few do.
As a result, you must understand that trying to predict fluctuations in foreign exchange (especially between a resource-based economy and the world’s largest economy) is a lot like predicting the weather. The professionals get it wrong as often as they get it right.
Don’t make the mistake of thinking that you have some insight that they lack. It often ends badly.