Canadians are gradually diversifying their portfolios beyond the domestic market, investing in stocks and bonds in the United States, Europe, Japan and emerging markets.
The shift follows years of marketing messages and advice from the financial industry that Canadians need to grow beyond their "domestic bias" and tap new opportunities abroad.
But as investors venture into foreign markets, they must consider not just the usual fundamentals but also the likely direction of that market's currency in relation to the Canadian dollar. These are two separate factors to weigh, which many investors are mistakenly lumping into a single decision.
"Too often, it's a decision that is ignored or deemed to be a 'bundled decision,'" says Paul Taylor, Toronto-based chief investment officer for asset allocation at BMO Global Asset Management.
Investors should instead be asking themselves two questions, he says: "What market do I want to be in?" and "What currency do I want to be in?"
Increasingly, Canadians are opting to put some of their cash in markets outside their borders. For example, U.S. equities accounted for 13.3 per cent of all the investments Canadians held through ETFs at the end of November, up from 9.8 per cent a year earlier. Holdings of international funds also rose, to 3.1 per cent of the total value, up from 2.3 per cent in the same period, according to the Canadian ETF Association.
"A big move in the Canadian dollar can amplify gains or losses [in foreign markets]," says Colin Cieszynski, Toronto-based chief market strategist for CMC Markets Canada. "Currency is something that should be a part of your investing thinking."
Investors should be applying the same level of analysis to the currencies in their trade as they do to the fundamentals of an equity or stock market, which means assessing factors such as employment levels, GDP growth and inflation, Mr. Cieszynski says.
As the loonie lost 9 per cent of its value against the greenback in 2014, Canadians who held U.S. stocks and bonds in U.S. currency during the year received a bonus on top of any gains in the underlying asset.
Shaun Dookhoo, a 35-year-old investor in Milton, Ont., began converting most of his investment funds into U.S. dollars several years ago, when the Canadian dollar was near par with the greenback. He felt at the time, and continues to believe today, that the larger U.S. market offers greater opportunity than the domestic market. Even with the loonie in the low 80-cent range today, he has continued to convert funds to U.S. dollars, believing that the Canadian dollar is overvalued and will eventually settle in the low 70-cent range.
But investors who believe that the loonie will actually rise in value during the time that they hold U.S. stocks or bonds might consider hedging their investment to the Canadian dollar, to make sure any investment gains are not eroded upon conversion back to Canadian funds.
The simplest way to hedge the loonie is by buying foreign stocks and bonds through either a mutual fund or ETF that is denominated in Canadian currency. But it's important to remember that even when you choose to offset the risk of currency swings by using a hedged product, you are still making a decision on which way you think the currencies in your trade will move.
While Mr. Dookhoo has looked at some of the investment products that hedge for the Canadian dollar, he has opted to keep his foreign currency exposure. "I believe that currency is an opportunity to capitalize on," he says. "And I prefer to change between currencies myself because it gives me greater control."
He keeps his investments in a U.S. dollar account, an option most Canadian brokerages now offer to clients, so he doesn't incur foreign exchange fees with each sale. U.S. dollar accounts also offer another way to dampen the effects of currency swings, by allowing an investor to hold the greenback for the long term.
Most economists and market strategists are calling for the Canadian dollar to continue weakening against the U.S. currency. Mr. Cieszynski expects the loonie to remain in the 80-cent range for an additional one or two years, as members of the Organization of Petroleum Exporting Countries and other energy exporters keep the global market awash in cheap oil and gas. That suggests that it's not too late for Canadian investors buying into the U.S. market to do so without hedging.
It's looking like a different story in Europe, however. Broad expectations that the European Central Bank will be forced to launch a massive round of stimulus, while continuing to keep lending rates near zero per cent, will cause the euro to depreciate further against both the U.S. and Canadian dollars, Mr. Taylor says.
"Investors [in Eurozone markets] would be well-served to be hedged back into the Canadian or U.S. dollars," he advises.
It is a similar currency story in Japan, where Prime Minister Shinzo Abe's recent re-election victory will ensure that stimulus keeps flowing to try to resuscitate the economy. Mr. Taylor forecasts that the yen – which is already at a seven-year low against the greenback – could depreciate an additional 12 to 15 per cent against the U.S. currency. As a result, he advises that investors hedge any investments in Japan to the Canadian dollar.
It's important for Canadians to have some currency diversification, even if that means having just a few holdings in U.S. dollars. It's also essential that investors be aware of their currency allotments so they can manage the risks, he said.