The Canadian dollar has not been the strongest currency in recent years. There are many factors that determine the strength of a country’s currency. The value of the Canadian dollar will rise or fall based on supply and demand. Said another way, our dollar will fluctuate according to how many people in foreign exchange markets want to buy and sell it. It is for this reason that currency will float in value as the Bank of Canada (BOC) doesn’t try to set the dollar’s exchange rate.
Although the BOC doesn’t try to set the exchange rate, they do set key interest rates, which is a big factor in how our currency floats. Inflation and growth in the domestic economy are also key. If investment dollars are not flowing into Canada (i.e. lack of confidence in current government policy), this also has a big impact. The country’s balance of trade is also a factor that impacts the currency rate.
Discussion about currencies
When we first begin working with new clients, we will always spend time talking about currencies with respect to investing. This is especially the case when we have provided a second opinion where an individual has a portfolio that is 100 per cent denominated in Canadian dollars. Over 60 per cent of our model portfolio is denominated in currencies outside of the Canadian dollar. To begin the conversation, we talk about how Canada represents only 2.7 per cent of the world’s market capitalization. The United States, on the other hand, represents 58.4 percent.
We also outline how we have assisted our other clients with respect to currencies. The most common foreign currencies we assist client transactions with are the United States dollars, Euros, British Pounds, Mexican Pesos, Japanese Yen and South African Rand. Except for the U.S. dollar, nearly all the conversions we help clients with are for specific transactions relating to receiving/sending inheritance, transferring funds from abroad back to Canada, sending funds to family members in different countries, travel money, or relocating to a different country for work or retirement. Over 90 per cent of the currency conversions we do for clients is between the United States dollar (USD) and the Canadian dollar (CAD).
Diversification of investments
We feel strongly that Canadians who add foreign investments and foreign currencies to their investment portfolio will have superior investment performance over time when compared to an investor who limits investments to the Canadian equity market and the Canadian dollar. Over the last couple of decades, we have also seen how geographic diversification can smooth out portfolio volatility. It is easy to review historical numbers which highlights how the US stock market has consistently outperformed the Canadian stock market over time. If you have ever walked into a financial institution and looked on the wall, you may see an Andex chart. This chart shows a range of financial data through different time periods. The chart highlights the importance of a long-term investment approach and diversifying outside of Canada.
When we first begin talking with clients, we discuss the risks and rewards of different approaches to investing. At the bottom end of the risk chart is keeping money in a Canadian dollar (CAD) Investment Savings Account (ISA) or Guaranteed Investment Certificate (GIC). By keeping funds in CAD, you are reducing currency risk; however, the reward is limited as well. It is possible for clients to purchase a U.S. dollar (USD) denominated ISA or GIC. Fluctuations in the exchange rate between the USD and CAD will impact the net return calculated in CAD. It is possible for investors to speculate with respect to currencies. By speculating, we mean that you are purposely betting one currency will perform better or worse than another – often for short-term trades. Our approach to currency exposure is not to speculate. Our currency exposure is meant to add exposure to equities outside of Canada and add diversification to smooth out volatility over time.
Total rate of return
The total rate of return on a Canadian security in our model portfolio is the sum of the change in the share price (from the original date of purchase to the disposition date) plus the dividends received over time. The total rate of return on a USD security in our model portfolio is the same as the Canadian security plus the change in the USD currency. If, for example, we purchased a USD security when the USD was at 1.20, and we sell the U.S. security when the dollar is at 1.30, we have effectively made an 8.33 per cent (0.10/1.20) currency gain. If we purchase a U.S. security when the USD was at 1.30 and we sell the U.S. security when the dollar is 1.22, the currency loss would be 6.15 per cent [(1.22-1.30)/1.30]. The total rate of return on a foreign security will be the dividend, plus the change in value of the security’s share price, plus the change in the foreign currency relative to the Canadian dollar. Below, we have illustrated this with both a positive movement in the currency and a negative movement in the currency.
Illustration: Positive foreign currency
To illustrate the positive contribution to currency, and to the overall rate of return, we will use ABC Company, which does not pay a dividend. To illustrate, we will assume 300 shares of ABC Company were purchased at the beginning of the year when the share price was $78.00 and the USD to CAD exchange rate was 1.20. The total cost in Canadian dollars was $28,080.00 (300 shares x 78.00 x 1.20). At the end of the year, the share price of ABC Company had declined to $72.40; however, the USD to CAD exchange rate was 1.36. The value of ABC Company at the end of the year, in CAD, is $29,539.20 (300 shares x $72.40 x 1.36). Effectively, an unrealized gain of $1,459.20 has occurred, even though the share price of ABC Company had declined $5.60. The unrealized gain is a result of the USD strengthening relative to the CAD.
Illustration: Negative foreign currency
To illustrate the negative contribution to currency, and to overall rate of return, we will use XYZ Company, which does not pay a dividend. To illustrate, we will assume 400 shares of XYZ Company were purchased at the beginning of the year when the share price is $69.70 and the USD to CAD exchange rate was 1.30. The total cost in Canadian dollars was $36,244.00 (400 shares x 69.70 x 1.30). At the end of the year, the share price of XYZ Company had increased to $76.40; however, the USD to CAD exchange rate was 1.17. The value of XYZ Company at the end of the year, in CAD, is $35,755.20 (400 shares x $76.40 x 1.17). Effectively, an unrealized loss of $488.80 has occurred, even though the share price of XYZ Company had increased $6.70 per share. The unrealized loss is a result of the USD weakening relative to the CAD.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email firstname.lastname@example.org, or visit greenardgroup.com.