The Role of Currency in an Investment Portfolio

I just spit out my coffee all over my desk. Not because it tasted bad or because it was too hot. I was on the phone with one of my old friends when it happened. You see, he was telling me that he was unloading some property in the US and that he was considering exchanging his money immediately out of the US dollar once he gets it. OK fine, that wasn’t my choking moment. It was when he said, “I’m thinking of exchanging everything to the Euro because it’s better than the US dollar, and I think the Euro will one day be the reserve currency”. Spit.

Part of any investment strategy is to at least try and get the “big picture” right. Perhaps the Euro which is experiencing a very overcrowded short position will have a nice pop in the short term. However, in a big picture way, and longer term, to become the reserve currency is a long shot and I would not place my money on. Currency can play a big role in the outcome of investment returns and when taken in the context of an investment portfolio, it should be analyzed as a risk to either mitigate or not. First, here is a refresher on the basics of the currency markets:

Here in Canada, the majority of investors use Canadian money to invest abroad. When doing so, our loonie will get converted to the appropriate currency of the country being invested in. But it is always traded with the US dollar before it moves to another currency. This is called the cross trade.

Basically there are three major currencies that trade on the market; the US dollar, the Japanese Yen, and the Euro. Everything else is cross traded against one or two those three. For instance, if a Canadian investor wants to buy the Bolivian Boliviano known as the BOB, their Canadian dollars are first exchanged to US dollars; the cross trade. Though they don’t disclose all of the “crosses” used to eventually get to the BOB, typically, a quote is given and the investor chooses to take it or not. How a regular investor eventually goes from a Loonie to a BOB is all done behind the scenes with the currency traders.

The point is, when an investor converts to another currency, the US dollar always plays a role in the trade. Traditional investors have to determine their outlook for the US dollar as well as other currencies to determine whether it warrants hedging out the risk or not.

As an example of how currency can affect the returns on an investment portfolio I have included this chart which shows various index percentage returns year to date (May 31st 2010) based in the local currency of the respective country, and then, the same index converted to Canadian currency.

Dow Jones Industrial Avg. -2.79% and in Canadian Currency -3.05%
S&P 500 2.30% and in Canadian Currency -2.56%
NASDAQ Composite -.53% and in Canadian Currency -.80%
S&P/TSX Composite -.15% (Canadian currency)
German DAX Index +.43% and in Canadian Currency -13.91%
FTSE MIB Index -15.87% and in Canadian Currency -27.88%
Swiss Market -3.2% and in Canadian Currency -13.49
Hang Seng Index -9.63% and in Canadian Currency -10.32

(source Bloomberg World Equity Indexes Year to Date May 31st 2010 9:33 AM EST)

Based on this data, it would have been wise to use a currency hedge in an investment portfolio. Had an investor used Canadian currency and converted to the Euro in order to invest in the German DAX index and then cashed out and converted back to Canadian dollars, they would have lost money instead of made money (based on the above time frame). Going forward, to hedge or not is based on what one thinks of the global macro picture.

My Big Picture:

Personally, I think the macro picture when it comes to currency is very uncertain and will most likely be very volatile. With sovereign debt in abundance, risk of deflation, risk of another recession, all within the scope of already low interest rates, just makes me think the only tool in the tool box to be used is a global race to currency devaluation. Since I’m not a currency speculator, I prefer to mitigate currency risk in investment portfolios for the time being.

Now, I need another cup of coffee.

Susan Mallin works with MGI Securities as a Toronto-based investment advisor . As an investment advisor at MGI Securities, Susan is able to offer clients a full suite of investment services and investment products. Her process was designed to guide clients through a sea of choices in order to help them make decisions, in a manner that is simple yet effective, throughout the journey of reaching their financial goals. Susan’s investment practice isn’t focused on account size or age. It’s about desire, attitude and willingness to succeed.

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