Thursday, 8 February 2007

Foreign Investments and Currency Risk

At one point in 2006, the US market was rising but my investments were declining in Canadian dollars! The US dollar was going down faster against the Canadian dollar than the US market was going up. One could easily end up skeptical about the wisdom of international diversification, which Efficient Market Canada does a fine job explaining in its article Building a Globally Efficient ETF Portfolio, updated in January for 2007.

Since the objective of international diversification is not to simultaneously bet on foreign currency markets, at least for me, what can be done to avoid or wash out exchange rate effects? One way to counterbalance currency effects would be to buy a specialised ETFs such as FXC - Canadian Dollar Currency Trust. Here's a Wall Street Journal article that tells all about it, and another at the Motley Fool, but the basic idea is to buy the FXC ETF so if the Canadian dollar rises, the FXC fund rises proportionally, offsetting the fall in the value of the actual US equity fund, such as IVV iShares S&P 500. If one holds a number of different US ETFs and equities, one could add up all their value and hold an equivalent amount in the FXC to be rid of currency shift effects. This is getting a bit complicated and requires doubling the overall amount invested - the total of IVV plus an equal amount of FXC - and it doesn't address the rest of world, so what else can be done?

A reasonable solution for US and international diversification to eliminate currency risk that I have found is to buy iShares Canada funds such as XSP and XIN, both traded on the TSX. Both are hedged to Canadian dollars, i.e. iShares does the currency trading to wash out the currency risk. XSP tracks the S&P 500 while XIN tracks the MSCI EAFE Index that includes 21 MSCI country indices of developed markets outside North America - Europe, Australasia and the Far East. Claymore Investments Inc. has more recently entered the market with a similar hedged ETF, the CLU (the FTSE RAFI US 1000 Index). Claymore also offers CBQ (tracking companies in Brazil, Russia, India and China), though this latter fund is hedged only to US dollars since it comprises equities traded in New York and it tracks companies it has selected using a proprietary method, not indices. Go here to get the Claymore explanations.

I do have holdings in XSP and IVV but not any (yet) of the other funds mentioned.

The fundamental reason for getting rid of currency risk is that one needs to have the profits of investments in the currency of the country where one spends the money. If one travels or spends or spends time in the US, then it makes sense to have US dollars so then one would NOT want to eliminate currency risk.

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