In my last post I argued that Canadians should avoid currency hedging in their equity portfolios. Not only does exposure to the US dollar and other foreign currencies add a layer of diversification, but hedging strategies can be imprecise and ineffective. I ended that article by encouraging investors to simply “use a rebalancing strategy to smooth out the ride.” Let’s explore that idea a little more.

The first point to understand before we go further is that you should measure your investment returns in Canadian dollars, even if some of your assets are denominated in other currencies. Indeed, you’re probably already doing that, especially if you hold US and international equities through mutual funds or Canadian-listed ETFs. The net asset value of these funds is always given in Canadian dollars, and any fluctuations in foreign exchange rates is already factored in. Even if you use US-listed ETFs, most online brokerages display the market value of your holdings in Canadian dollars, but if you’re looking at the funds’ US websites or getting quotes on Google Finance, you may be misled by returns given in US dollars.

The second key idea is that when you own foreign equities, you actually own two assets: the stocks themselves, and the currency in which they are denominated. These exposures will affect your returns—as measured in Canadian dollars—more or less independently. And therefore you need to consider both when managing and rebalancing your portfolio.

Back to balance

Say an investor we’ll call Conway has a $50,000 portfolio with a target mix of half Canadian and half US equities. Conway uses a US-listed ETF for his American holdings. If we assume the loonie and the US dollar are at par when he implements his portfolio, his holdings start off like this:

Value in CADValue in USD%
Canadian equity$25,00050%
US equity$25,000$25,00050%

Now fast-forward a year and assume (albeit unrealistically) that both Canadian and US stocks have not changed in value in their local currencies, but the Canadian dollar has depreciated sharply and is now worth $0.80 USD. Conway’s portfolio now looks like this:

Value in CADValue in USD%
Canadian equity$25,00044%
US equity$31,250$25,00056%

Notice that the value of the US holdings is unchanged in USD terms, but Conway measures his returns in Canadian dollars, and the soaring greenback means he’s enjoyed a significant bump in the value of his US equity holdings. In fact, the portfolio is now well off its target and it’s time to rebalance.

Since the portfolio is now valued at $56,250, Conway should hold half that amount ($28,125) in each of his two asset classes. So he simply sells $3,125 CAD worth of his US holdings and adds that money to his Canadian equity holdings. With the loonie at $0.80 USD, he needs to sell $2,250 USD worth of his ETF in order to collect $3,125 CAD in proceeds. When these transactions are complete, Conway’s portfolio is back to balance:

Value in CADValue in USD%
Canadian equity$28,12550%
US equity$28,125$22,50050%

In this example, the stocks themselves have not changed in value, but their currency has appreciated by 25%. If the US-Canadian exchange rate had remained unchanged but the stocks had increased by 25%, the effect would have been the same. Conway should therefore take the same action in both cases: rebalance back to his target asset mix in Canadian-dollar terms.

Stick to the math

It’s easy to make this decision more complicated than it needs to be. Investors wonder aloud whether the US dollar is “overvalued.” Wouldn’t it make sense to switch to a currency-hedged strategy to protect yourself from its “inevitable” correction? Does an 80-cent loonie change the game fundamentally, and is it time to think about reducing the exposure to US dollars in your long-term asset mix?

These ideas sound sensible, but the problem is always the same: no one can predict the movements of exchange rates, any more than they can forecast stock markets or interest rates. It’s hard to understand how any investor can fail to appreciate that after the last five years or so. This unpredictability is precisely why we build balanced portfolios with multiple risk factors—including currency exposure—and hold those assets all the time.

You can make a bet on one possible outcome and hope you get lucky. Or you can diversify broadly, rebalance regularly and take comfort in the fact that being half right is better than being dead wrong.