Hedge your bets

The Canadian dollar’s rebound in January to over $0.65 (U.S.) has prompted some people to question my long-time currency hedging strategy.One reader wrote: “Gordon Pape has always suggested that investors should hold a good percentage of their assets (at least 30 per cent) in securities denominated in other currencies, with U.S. dollars as the number one choice. However, with the U.S. dollar value expected to fall further in the near future, what is the logic for this strategy?”

It’s a reasonable question, particularly in the light of what’s happening in the currency markets these days. So let me explain my philosophy in somewhat greater depth.

Insurance, not speculation
The strategy I recommend might best be described as currency insurance. It’s important to understand the distinction between that and currency speculation.

Our reader is correct in saying that the U.S. dollar is generally expected to fall in value in the near term against not only our currency but also the euro and the Swiss franc. The greenback has already dropped significantly against the euro, but many currency traders expect it decline at least another 10 per cent and perhaps as much as 20 per cent. That’s one reason gold has been so strong recently.

The Canadian dollar has benefited from the greenback’s weakening to some extent, and should continue to do so, although it is unlikely to match the euro’s strength.

For a currency speculator or money manager, that suggests that a bet on the euro right now looks like a pretty good strategy.

Investors who don’t want to plunge into the world of currency options can use the Mackenzie Universal World Tactical Bond Fund for this purpose. Recently it held 45.5 per cent of its assets in Germany and France for euro exposure, with another 6.5 per cent in Britain. Only 24 per cent of the fund was in U.S. dollars.

Long-term trend: Canadian dollar lower
However, my long-term approach is to come at this issue from a different perspective, a very practical one. I don’t pretend to be able to predict the short-term direction of currency movements. However, I do know that the long-term trend line of the Canadian dollar against its U.S. counterpart is down, although it occasionally rallies a bit, as it has recently.

Perhaps you’ve heard the radio commercials from Synergy Mutual Funds in which they talk about a man on an up escalator playing with a yo-yo. The yo-yo is the stock market, so it is continually going up and down in the short term. But in the long term, the escalator carries both man and yo-yo upwards.

The performance of the Canadian dollar is much the same, only in this case the escalator has been going down for something like 40 years.

This has created financial problems for anyone who spends a considerable amount of time in the U.S., such as retired snowbirds, and who does not have access to sources of American cash. They must constantly exchange their loonies for U.S. dollars at the current day’s spot rate, which is usually lower than it was the last time they went to the bank. That has made it increasingly difficult for some people to enjoy the type of retirement lifestyle they had expected and dreamed of.

Which currency are you likely to spend?
Holding a portion of your assets in U.S. dollars provides some currency insurance against a continued trip down the Canadian currency escalator. I use U.S. dollars in my examples because that’s the currency which most people will need, not because I believe it is the strongest currency right now. If your retirement plans are likely to have you spending more time in Europe than in the U.S., substitute euros for greenbacks and create your “insurance policy” on that basis.

As to the percentage of assets to be held in other currencies, 30 per cent is not a hard rule by any means. It depends entirely on your future plans and needs. If you never intend to set foot outside our borders and don’t need foreign currency for any other purpose, don’t worry about it – unless you just want to protect future purchasing power in the event the loonie should fall to $0.50 (U.S.), as some pessimists have predicted.

What if your currency of choice declines in value against the loonie? Consider the cost to be your insurance premium. If the loonie is the currency that drops, look at your profit as a dividend. But either way, you still own the U.S. dollars or euros or Swiss francs or whatever currency it is that you will need for your own personal purposes.

Adapted from an article that originally appeared in the Internet Wealth Builder, a monthly electronic newsletter of common sense mutual fund advice edited by Gordon Pape. To take advantage of a three-month trial subscription available to 50plus.com users for just $19.97 plus tax, go http://www.buildingwealth.ca/promotion/50plusproducts.htm