Brad Ferris'  Instablog

I’ve mentioned a few times in past posts the importance of identifying unsustainable trends in the economy and business cycles of companies. Every investor needs to be proactive in their investing activities to identify risk because far too often each of us are solely reactive to developments in the market and this leads to significant losses of our capital and opportunity for gains. Trees never grow to the sky and when a stock chart or market goes parabolic gravity has a sickening effect on the scale and speed of its inevitable descent.

I practice diversification by investing outside of Canada and this directly exposes me to varying degrees of currency risk each time I purchase a foreign stock, bond, mutual fund or ETF. As a long-term investor I recognize that volatility in FOREX (foreign exchange) comes with the territory of being diversified globally and that over the long-term currency fluctuations tend to even out. But as an investor in the accumulation phase of his portfolio construction I’m concerned about the short-term effect of currency volatility because it can impact the price I pay for an investment and any gains (income, capital gains, interest) I subsequently receive. While I view currency exchange as a cost of investing I want to always minimize my exposure to costs as much as possible because costs directly impact my ability to achieve short-term gains and compound long-term results.

Calculating a fair-value for what you want to pay for any foreign currency is difficult, but I tend to look to historical averages to get a sense of how far in one direction or another the specific currency has moved. Last year the Canadian Dollar (CDN$) traded well above its historical average to a high near $1.13US and you didn’t have to be an economist to figure out the dramatic effect that would have on our export economy; the valuation was unsustainable. My expectation of where the CDN$ will trade over the next decade or more is between $0.75-0.85US and if I have an opportunity to trade my loonies at par with the USD I view that as a key short-term opportunity. My expectation is that in the future when I contribute to my RSP to invest in US stocks I’ll likely get $0.75-0.85US for each CDN$. The problem for many investors is that they buy US stocks with CDN$’s, receive dividends in USD and then convert that those dividends back into CDN$’s. The costs incurred from all these activities can add up quickly and significantly diminish investor returns.

In my situation I’ve chosen to keep all foreign equities and fixed income investments in my RSP to minimize taxation (exempt from 15% withholding tax), decrease my foreign currency costs and maximize compounding growth. The only time I purchase USD is when I make a contribution to my RSP and all subsequent dividends are paid and maintained in USD within the account.

Although I believe that over the long-term (20-30 years) currency fluctuations cancel each other out any short-term devaluation of the CDN$ will hurt my ability to contribute the same amount of cash to my RSP for USD denominated purchases.

What I wanted to do was hedge to some degree my recent RSP contributions and planned contributions for 2008-2010 as I expected the CDN$ to depreciate back towards a more sustainable level. It would be difficult to completely hedge my entire position (too costly), but with oil at an apparently unsustainable bubble and the CDN$ moving so closely instep with the price of crude oil (in USD) I decided to place a small hedge in my RSP to help buffer any potential slide in currency valuations. My major motivation for this move was to maintain my purchasing power within the RSP without losing a significant value of it in CDN$’s. The intention of the hedge is to act as an insurance policy. If the valuation of the CDN$ doesn’t change I don’t need the hedge and can eventually sell it for only a loss of opportunity cost. If the CDN$ depreciates significantly I can sell the hedge off in pieces and use/combine the proceeds to make purchases within my RSP to offset the unhedged loss of value in CDN$ when I make new contributions to my RSP account. When I contribute new money from outside my RSP (in CDN$) the loss of purchasing power isn’t as significant because the hedge acts as a balancer.

Example:

Say I contributed $5,000 CDN to my RSP at parity, received $5,000 USD and purchased my hedge for the full amount. In twelve months the parity between currencies has now moved so that the CDN$ is worth $0.80US. What I can now do is contribute the same amount to my RSP in CDN$ ($5,000) as before and sell $1,000 of my hedge to achieve my desired contribution of $5,000 USD.

My choice for the hedge last summer was the PowerShares Double Short Oil ETF (DTO). The reason for choosing the double short ETF versus a regular short ETF was that I didn’t need to expose as much of my capital at risk for the same effect, the ETF was already priced in USD and the correlation of the price of oil to the CDN$ was closer than other alternatives. The effectiveness of this intended strategy was that the hedge would increase at double the decline of the CDN$. I bought the shares in July of 2008 and slowly over the past year began selling small portions of the hedge as the CDN$ and oil depreciated.

As mentioned before my intention is to not fully hedge my RSP over the long-term due to the historical ranges that many currencies range in over time and an inability of any investor to accurately anticipate the direction of valuations of currencies. But as a young investor focused on accumulating assets for future wealth I wanted to protect my purchasing power now without having to add a higher amount in contributions for the same effect. This strategy was fairly simple to implement and shows that an investor doesn’t have to do an “all or nothing” hedge. Having a small position in key investments can protect a portion of your portfolio and at times that’s all you need. The mistake many investors make is they feel they need to hedge their entire position for risk when only half or less can do the trick for the intended effect.

Disclosure: I currently do not hold any shares of DTO.