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moneysense.ca, 21/02/07
Reader Question: Rebalancing and Currency Exposure
The following question is from Stephen:
Should I rebalance my portfolio ignoring changes in the currency rate or rebalance post currency adjustment? And does it make a difference based on how the USD is doing against other currencies (i.e., if it’s only weakening against the Canadian dollar because oil prices shoot up, or if it’s weakening against all currencies based on trade deficits)?
In my personal portfolios, I track the asset allocation in Canadian dollars by converting foreign holdings into Canadian dollars using the prevailing exchange rate. I believe that investors with a reasonably long-term view (more than 10 years) should ignore currency fluctuations, as it is impossible to precisely predict currency movements even in the near-term. I think it is best to keep things simple and rebalance using current exchange rates. Doing so would help us sell US equities when the US dollar is in the higher end of its range and buying them when the loonie is stronger. After all, I don’t recall many analysts predicting a 90-cent dollar in 2002, when the loonie was below 65 cents.
Related: To Hedge or Not To Hedge
moneysense.ca, 21/02/07
If you look at historical currency fluctuations, they tend to wash over time. If you are invested for the long term (10+ years), I agree, I would ignore currency fluctuations. Hedging currency is a net cost to a portfolio and predicting them is impossible. Hedging currency has become a hot debate among Canadian investment managers because their US returns have suffered due to the rise of the Canadian dollar over the past several years.
CrunchMoney – I don’t think it’s fair to say that historical currency fluctuations wash over time. For instance, look at rolling 10 and 20 year average percentage change in USD/CAD exchange rates from 1971 (the year after Canada floated its currency again) to 2006.
Using the monthly average exchange rate, the average 10 and 20 year change was 9.35% and 15.21% respectively. Not only that, the standard deviation on these averages was 13 and 14 percentage respectively (I used data available from UBC).
I think it’s important to be aware of this long currency risk, but that doesn’t necessarily mean you should do anything to hedge against this risk. I like the Capitalist’s idea to take the current exchange rate when rebalancing, and not attempt to predict where the rate is going to go.
I agree. As an individual investor I think there is very little gain in trying to either hedge currency (because of cost) or predict it (because no one can do it accurately). I think that instead it’s important to limit the percent of your portfolio (based on risk) that’s exposed to international currencies. Although international currency exposure provides some diversity to a portfolio you will ultimately be retiring in the dollars of your country.
MCM,
http://middleclassmillionaire.blogspot.com/
I agree that for Canadians planning to spend their money in Canada, one wants to measure and to rebalance things in C$. There is a vehicle to get the gains from foreign equity diversification that washes out currency fluctuations, at a reasonable cost in my view, in the form of iShares ETF funds XSP (S&P500) and XIN (MSCI EAFE). Given the observed large and often quick currency changes it’s worth the management fees and the tracking error those funds entail.
Since the currency fluctuations tend to wash over time, currency risk yields no net benefit to a long-term investor. As well, there are no long-term growth prospects in investing in foreign currencies. Assuming a 10% average return, a 0.15% per annum cost to hedge, and a 45 year investment horizon, a $1000 portfolio would become
Unhedged: $72 890
Hedged: $68 550
Difference: $4 340
The hedged portfolio is worth about 6% less than the unhedged portfolio. Given the volatility of exchange rates, the unhedged portfolio’s 6% advantage could be quickly lost to a strengthening local currency.
As the cost of hedging is minimal and the growth prospects of holding foreign currency are non-existent, I would suggest holding currency neutral investments.
[...] debate as to whether you should think about currency fluctuations if you have a long term view (see this Canadian Capitalist post for instance). While I think it’s hard to determine where the currency rate will be in the far future, I [...]