The Canadian dollar to US dollar exchange rate changes over time and can impact the value of your investments. The exchange rate is closely related to commodity prices, particularly oil, as can be seen in the below chart.
Recently, there was a relatively large uptick after the Bank of Canada raised its key rate by one quarter of a point to 0.75% on July 12th, 2017. They also set the stage for further rate hikes which put more upward pressure on the loonie as the spread between the US and Canadian rates narrowed.
What a Stronger Loonie means for Canadian Investors
A strengthening of the Canadian dollar can affect the investments of Canadian investors.
Canadian mutual funds often invest in US and global securities, which are generally priced in their respective national currencies. This exposes Canadian investors to fluctuations in currency exchange rates. The total return of such a fund comes from adding the change in the price of the underlying security with the change in the exchange rate of the currency of the US or global securities.
Mutual funds sold in Canada are valued in Canadian dollars. Therefore, all things being equal, when the loonie rises, the value of US securities falls in Canadian-dollar terms. If the loonie declines, the value of US securities increases.
The diagram below illustrates the effect of a strong Canadian dollar against a basket of US-dollar securities and the effect on returns for you as a Canadian investor.
You sold the securities after the exchange rate increased in favor of the loonie. So while the value of the basket of US securities stayed the same in US dollars, the value of the securities in Canadian dollars decreased.
The Protective Hedge
Hedging can be used by portfolio managers to reduce the impact that changes in currency values can have on an investment. For instance, hedging can be used to remove the effects of exchange rates for a Canadian investor, who then is only exposed to the changing returns of the securities. A mutual fund may try to hedge all, some or none of its foreign currency exposures.
Choose Companies over Currencies
The investment risks posed by changing exchange rates emphasizes the importance of investing in companies, not in currencies. The shifts and turns of currencies are largely unpredictable and can be volatile, even dramatic, in the short term. However, over the long term, research studies have found that the effect of currency volatility tends to balance out.
This is why you should consider focusing on funds that buy the stocks of competitive companies at attractive prices. These are businesses that have long-term advantages in their industries and offer products and services that customers want.
A solid investment strategy is based on a long-term market outlook and the investor’s risk tolerance. Don’t let short-term currency fluctuations distract you from a steady strategy for the long run.