You may have wondered in the past few weeks why the global stock markets seem to be recovering but your investment accounts are not getting any bigger.
Since the beginning of April, stocks have been doing quite well. The S&P 500 is up around 5%, the Nasdaq 100 is up a bit more than that, the MSCI EAFE index is up around 4%, while the Emerging markets are more or less flat.
However, this gets completely turned around once we take a look at markets in Canadian-listed products. While XUU.TO and XEF.TO are basically flat, VEE.TO is actually down so far this month. What is going on?
The answer boils down to one factor... the value of the Canadian dollar has been climbing. This fits with the common themes we have been seeing from the Canadian dollar in the last few years. When the stock markets do poorly, the value of the Canadian dollar falls as well cushioning investor accounts from the full impact of the markets. The inverse is also true.
CAD vs. USD
The chart above is the Year-to-Date movement of the Canadian dollar relative to the U.S. dollar. The Canadian dollar fell in value quite a bit from the end of January though the middle of March before suddenly changing direction.
From the beginning of April, our dollar has leaped up around 2.5% against the U.S. dollar, jumping above the short term moving average I like to use: the 10-day EMA. The 10-day EMA is a great indicator of shorter term market movements. This is a big, solid move for any currency including the secondary currencies (Canadian dollar, Australian dollar, New Zealand dollar, Hong Kong dollar, Singapore dollar, and the Swiss franc are in this group).
The CAD/USD relationship directly impacts Canadian ETFs which hold U.S. stocks. My favorites include XUU.TO, ZSP.TO, HXS.TO, and XDU.TO.
XUU.TO vs. XUH.TO
The direct impact of a falling currency on stock portfolios can be seen in this chart. I compared XUU.TO (dark blue line) to its currency-hedged version XUH.TO (light blue line) from the recent market peak on January 29 to the recent low on April 2. The unhedged version with the full impact of the falling Canadian dollar during this time declined approximately half the amount of the underlying market!
The currency impact translates to the muted overall effect on your portfolio as mentioned above.
CAD vs. Euro
The Canadian dollar has also increased approximately 1.5% against the Euro since the beginning of April. This is important because the Euro is the largest currency component of the MSCI EAFE index.
Other larger currencies represented in the EAFE index are the Japanese yen and the British pound.
Currency Impacts When Investing
The question of currencies is always an important one when considering your investment strategy. It's also a topic that gets a lot of investing commentators very fired up.
Currency is an important consideration for Canadian investors precisely because we are a secondary currency market. Our currency sees large swings in value which are largely driven by resource market conditions.
Commentary surrounding currency hedging by U.S.-based personal finance folks should be ignored. It's like comparing apples to oranges. The U.S. dollar is by far the largest impact and most important currency in the world--setting the global prices for nearly all commodities and a significant volume of industrial trade. U.S. investors should rarely hedge their portfolios for precisely this reason.
As a trend following investor, I generally just invest with the longer-term trend including currency trends. This makes the decision about hedging easy. I pick a hedged version of international index ETFs when our currency is trending up and a standard index ETF when our currency is trending down. It's impossible to catch all the trends perfectly, and it's not possible to hedge effectively with Emerging markets, but this strategy largely serves the purpose.
For more static investors, I believe the answer is to mix products to get varied currency exposure. Buy bond ETFs that hold Canadian bonds where possible. When buying international bonds, use hedging to minimize currency impacts.
When purchasing stocks, generally stick with ETFs which are not currency-hedged. This gives you exposure to the major currencies like the U.S. dollar, Euro, Japanese yen, and British pound.
If your portfolio is large (seven figures or more) with a smaller than typical bond allocation, consider currency-hedging a portion of your stock ETFs. Targeting between one-third and one-half of your total portfolio in Canadian dollars is not a bad choice if you primarily spend Canadians dollars.
Alternatively, you can invest in a Leveraged ETF Strategy. By increasing your bonds (held in Canadian dollars) and using U.S.-listed leveraged ETFs, you can have a high Canadian dollar exposure providing interest income as well as full stock exposure in international currencies. Not only are your long-term investment returns likely to be higher than a boring Couch Potato portfolio, your risk levels are actually lower.
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