Question

Discuss how fluctuations in the value of the U.S. dollar could pose problems for Canadians buying and investing in the U.S.

Answer 1

Exchange rates are more volatile in the world of managed floating rates than during the period of U.S. expansion in the international economy. More and more, countries follow divergent monetary policies. At the same time, markets are becoming more global. The United States no longer has a 70% or 80% world market share in key industries but shares markets more equally with Europe and Japan.

For many Canadians, currency movements are an everyday part of life. When the Canadian dollar is strong, it means that going south of the border is cheaper. Whether it’s a vacation in Hawaii or a shopping spree in New York City, a strong Canadian dollar can buy more in terms of U.S. dollars. Likewise, a weak Canadian dollar can buy fewer U.S. dollars – meaning that travel, shopping, and other expenses in U.S. dollars are more expensive.

The impact of currency fluctuations isn’t limited only to foreign purchases. In fact, as today’s infographic from Fidelity Investments Canada shows, these same fluctuations can also affect the performance of your portfolio.

Many Canadian portfolios have exposure to American-listed companies such as Apple, Wells Fargo, Tesla, or Johnson & Johnson. As a result, fluctuations in the USD/CAD rate can have a profound impact on how these investments perform in Canadian dollars.

HOW DOES THIS WORK?

Here’s an example of the impact of currency in action:

A Canadian investor puts $100 CAD into a fund that buys U.S. stocks
At the time of investment, $1 CAD buys $0.80 USD
After exchange, $80 USD is invested in the U.S. market
The U.S. market goes up 10% in one year, and is now worth $88 USD
However, over the year, the exchange rate changed to $1 CAD per $0.85 USD
Converted back to Canadian dollars, at the new rate, the $88 USD is now worth $103.52 CAD, which is just a 3.5% gain in domestic Canadian currency

In the above case, a strengthening Canadian dollar ends up dampening the returns coming from the U.S. market.

In contrast, if the exchange rate went the other direction – meaning Canadian dollar was weakening – any returns would actually amplify.

LONG-TERM PLANNING

If currency fluctuations can have a substantial impact on investments, what does this mean for portfolio construction and assessing risk?

There are two main schools of thought on this:

Hedged: Some funds use a hedging strategy to try and cancel out any currency fluctuations. Ideally, the end result of this would be representative performance of the U.S. market.

Unhedged: This strategy does not try to anticipate currency fluctuations, since the long-term effects of currency movements tend to even out over time.

According to Fidelity Investments Canada, over the 20-year period of November 28, 1997 to November 30, 2017, the impact of currency fluctuations on the S&P 500 had a difference in annualized returns of 0.5%. In other words, U.S. dollars invested in the S&P 500 had a 7.2% return, while Canadian dollars invested in the same stocks had a 6.7% return after adjusting for exchange rates.