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Global Investment Portfolios – The FX Effect

By: Paul Resnick

The elimination of the foreign property rule will expose Canadian investors to fluctuations in the Canadian dollar versus other global currencies. Paul Resnick, of Intelligo Capital Corporation, examines some of the implications.

The proposed changes to the RRSP rules in the February Federal Budget will provide new challenges for Canadian-based investors. As investors grapple with the elimination of the foreign property rule, they will be potentially exposed to the fluctuations in the Canadian dollar versus other global currencies.

Mutual fund and pension fund managers with foreign exposure in their portfolios have always had to evaluate the risk/reward characteristics of an investment in a foreign bond or stock by taking the potential foreign exchange movements into account.

For a Canadian manager, the higher potential return from an unhedged investment in a stock or bond denominated in U.S. dollars – or Euros or U.K. pounds – could easily become a real loss if there is a strengthening in the Canadian dollar between the time the stock or bond is bought and subsequently sold.

‘Unworthy’ Of Managing
With a 30 per cent cap on foreigncontent, the FX (foreign exchange) effect might have been overlooked or deemed ‘unworthy’ of managing.

However, with the potential for a larger percentage of investments in foreignbased products, the FX effect looms large.

In addition to the elimination of the RRSP foreign-content limit, the RRSP contribution cap is to be raised $1,000 each year to a maximum $22,000 in 2009. Individuals will have to consider the FX effect in their decision whether to increase the foreign content of this potential additional investment. While it may be enticing to be able to tell your friends about your tremendous high yielding investment in the Hungarian bond market, if you don’t attempt to do some research into the currency component of the transaction, your friends may be wondering why you suddenly haven’t been returning their calls or emails. You may be tempted to report that you earned eight per cent interest on your one-year investment in the bond, however, your net return may in reality have been negative after accounting for the large rise in the Canadian dollar versus the Hungarian Forint (in the ‘real’ market, this trade would have actually earned you many new friends as the Hungarian Forint has strengthened approximately eight per cent over the past year while Hungarian one-year rates have fallen from 12.5 per cent to 7.25 per cent).

There have been a number of studies undertaken on the topic of the effect of currency movements on the risk and return of an investment portfolio. The evidence shows that an active currency overlay program can enhance the expected excess return of an international equity portfolio.

Overall Risk Level
In addition, by combining a currency hedging strategy with an active overlay strategy the overall risk level of the portfolio can be reduced. A paper from Goldman Sachs Asset Management (June 2004) entitled ‘Currency: An Untapped Alpha Source,’ found that currency managers have been able to improve the risk/return profile of a diversified portfolio (U.S. Equity – 45 per cent, International Equity – 20 per cent, Fixed Income – 35 per cent) using a tailored currency overlay program.

Global currency market volume is approaching $2 trillion per day, making it by far the world’s single largest capital market. In comparison, per day volume in the U.S. Treasury Bond market is approximately $430 billion.

One would think that with such huge liquidity, the currency market would also be characterized as a highly efficient market.

In one sense this is true, as it is easy and relatively cheap to buy/sell any actively traded currency pair.

‘Textbook Efficient Market’
However, in the classic, ‘textbook efficient market’ sense, the currency markets are anything but efficient. The efficient market hypothesis is an investment theory that states that prices in the market reflect and incorporate all relevant information at all times, therefore rendering it impossible to ‘beat the market.’

The currency market is unique in that the vast majority of participants involved in this market do not have profit maximization as a primary reason for being in the market. The central banks of the world, along with the huge number of importers/exporters and individuals that are involved in the currency market, either pay the current ‘spot’ price that is being offered or the forward price available from their bank or from a regulated futures exchange.

Central Banks buy or sell currency for a number of reasons, including effecting macroeconomic policy. Corporations trade currency to hedge business operations, while individuals trade currency primarily to enable their travel to different countries. The vast majority of participants in the currency market are price takers and there are many opportunities for active currency managers to exploit the inefficiencies in the market.

With this highly liquid, yet ‘inefficient’ global FX market thrust to the top of the investor radar screen, investors may now wish to add a new study to their investment education checklist: the FX Effect.

Paul Resnick is managing director of Intelligo Capital Corporation.

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