Thursday, 3 December 2009

The Historical Effect of Inflation and Currency on a Canadian Investor's International Portfolio

To figure out whether a portfolio has made any real gains, an investor must subtract inflation and include any currency gains or losses on international holdings.

Let's look at some past actual data, taken from a downloadable spreadsheet by Norbert Schlenker at Libra Investment Management.

Performance of an International Portfolio 1992 - 2009
The portfolio: growth-oriented combination of
- 35% fixed income (5% Canadian T-Bills, 30% All Canadian Bonds)
- 65% equities, of which 25% is Canadian (TSX Composite) and 40% is foreign (15% S&P 500, 15% EAFE developed countries, 10% Emerging Markets)
This portfolio would have achieved a 4.6% real annual compound return. That might seem low until one remembers that in most such comparisons inflation has not been removed and inflation accounted for about 1.8% return lost each year in this period.

The chart below for the test portfolio exhibits some typical benefits of holding a mix of different types of assets:
  • bonds and t-bills dampen and stabilize the swings of the total portfolio
  • individual equity classes have much wilder swings year to year than fixed income
  • the portfolio does better than T-bills and bonds alone
  • individual equity classes move together in some years and in opposite directions in other years, the non-correlation that provides diversification benefits

Inflation and Currency Effects
The real return chart above includes not just the market returns of the assets, it has taken account of inflation and currency swings.

The following chart shows how significant these factors can be. Inflation is a constant, unavoidable, always negative drag on the real value of investment returns. Currency shifts have been quite significant, both as a positive boost to, and as a negative reduction of, foreign returns. About half the time, the currency effect was positive (8 out of 18 years). In several years when most stock markets tanked worldwide, like 2000, 2001 and especially 2008, the currency swing benefited the Canadian investor.

It seems that the historical data does support the conclusion that currency hedging is not necessary for a longer term investor, as explained in our recent post Foreign Investment: to Hedge or Not to Hedge Currency, which discussed the pros and cons of hedging and how to do it if so desired.

The above charts still do not reflect exactly what an investor could have done in practice. To more accurately simulate a true investor experience, there would need to be a few more downward adjustments: 1) deduction of management fees, averaging around 0.3% per year for typical ETFs that cover these asset classes 2) rebalancing trading commissions to keep the portfolio at its target allocations in each asset class (e.g. 5 annual rebalancing trades at $10 each would be $50, or 0.1% yearly cost to a $50,000 portfolio). ETFs for all these asset classes did not exist in 1992 and higher cost mutual funds would have been the only investment vehicle. But today they are available, so such historical "what if" reconstructions can serve to form reasonable expectations of what might happen to a Canadian investor with an international portfolio.

For those who might like to play around and try out various combinations of types of assets, more scenarios and portfolio options can be tested out using the excellent spreadsheet. The spreadsheet includes all the basic building block asset classes like Canadian T-bills, short and long term bonds, real return bonds, TSX equities, the S&P 500 large cap, the Wilshire total US market, the MSCI EAFE (Europe, Australasia Far East developed countries), MSCI Emerging Markets and even gold. Foreign returns have been translated into Canadian dollars and yearly inflation effects are shown in tables of nominal and real (inflation removed) returns. The annual data has been updated to the end of 2008 and it goes as far back as 1970.

Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations. It is merely an examination of historical factors that an investor may wish to consider in making his/her own decisions.


Doctor said...

1st time here... some interesting posts. Cheers.

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