Thursday, 30 October 2008

A Falling Canadian Dollar Can be An Investor's Friend

The week of October 6th to 10th was remarkable in several respects. Stock markets around the world suffered horrible record-breaking declines as government attempts to deal with the credit crisis seemed not to be working. No market was immune. The Toronto TSX Index fell 16% in the week, the US S&P 500 Index dropped 18%.

The Canadian dollar (CAD) also fell off a cliff compared to the US dollar (USD). From a value of about $1.10 Canadian on Oct.3, by the end of the day on Oct.10th, the USD rose (i.e. CAD fell) to $1.19, an unprecedented 9% shift. But that fall in CAD was actually beneficial to the Canadian investor with foreign holdings.

Here's how this benefit worked. In the chart below, I've taken a popular Exchange Traded Fund similar to the S&P 500, the Vanguard Large Cap Index Fund (with NYSE trading symbol VV) and graphed it in its original USD value as well as its value converted to CAD. The result - instead of the 18% drop, a Canadian owner of VV would only have lost 9%.

On October 10th, the value of VV in Canadian dollars actually rose despite the continued decline of VV in US dollars because the currency effect was stronger.

Naturally, the effect can work the opposite way too. As the Canadian dollar rises against the US dollar or any foreign currency, as has occurred more gradually over the last several years, the value of foreign holdings will be reduced. The net effect depends on whether the currency shift is greater than the stock market movement.

The currency effect extends to all currencies, not just the US dollar. An investor with a holding such as iShares Europe, Australasia and Far East Index Fund (traded in the US on AMEX under symbol EFA and available to Canadian investors) sees its value change according to foreign stock market results in those countries as well as the movement of the many national currencies such as Great Britain's pound sterling, Japan's yen, Europe's euro etc against the Canadian dollar. Note that EFA, despite being sold on a US exchange in US dollars, is actually not influenced by the US dollar, only the Canadian dollar and the other foreign currencies. CanadianFinancialDIY explains why this is so.

In the past year, the Canadian dollar has gone down simultaneously against most currencies. The chart below shows CAD vs other currencies from the RatesFX website.

This has helped cushion the brutal declines in stock markets around the world for an investor with internationally diversified holdings.

Although it is possible to buy funds that remove the fluctuations due to currency by hedging - an example being the iShares Hedged EAFE Index Fund (symbol XIN on the TSX), which is the same as EFA except with currency effects removed - most professional fund managers do not think the costs of hedging worthwhile. Currency swings tend to run out of sync with market moves and reduce the volatility of a portfolio with international holdings. This is a benefit to the investor, as seen during the gut-wrenching week of October 6th to 10th, 2008.

2 comments:

irradiant said...

What was it that caused the US dollar to surge in late October? I am a Canadian who was in Europe at the time, and though the Canadian dollar still dropped compared to the Euro, the change relative to the US dollar was incredible - when I saw the rates, I started using a US funds credit card rather than a Canadian one to take advantage of it. With the financial crisis, I was not expecting that at all!

CanadianInvestor said...

The most common explanation I've seen is that forced repatriation of funds on a massive scale by US hedge funds following losses in US markets, i.e. selling foreign assets, caused the shift, possibly combined with a flight to safety. This review from CIBC economics discusses the phenomenon: http://research.cibcwm.com/economic_public/download/fxoct08.pdf. Note how the CAD is forecast to recover in the next year or so.