The Loonie Watch Is On!

Last week, for the first time in 30 years, the Canadian dollar tipped over US$0.97, leaving only three tiny cents before potentially hitting parity with the greenback. And it is not just our dollar’s performance in comparison to the U.S. dollar either that has everyone so excited. So far in 2007, the “loonie” has gained against other major currencies as well, particularly the Japanese yen and the euro.

The loonie’s rather spectacular performance and strength are fuelled by both sides of the border. In the U.S., it was sluggish retail sales and decreasing economic output. In Canada, it was the fast-tracked rebound in the manufacturing sector and healthy housing and jobs markets, in addition to vigorous international trade activity.

However, there is sure to be one party not so happy with the loonie performing so well and even hitting parity with the U.S. dollar — the Canadian global investor. Because of the loonie’s recent strength, many global portfolios must have taken a beating, especially if investments held within them were denominated in the U.S. dollar.

Now, in the course of 2007, the Canadian dollar has not offered a steadily increasing uptrend, but rather a see-sawed trend line, which indicates considerable volatility. Furthermore, economists employed by Canada’s major banks are all over the board with their economic forecasts as to the loonie’s future path. And while the loonie watch is on, there is something that investors can do to protect their global portfolios — alleviate the foreign exchange risk.

Agreed; ordinary investors are not likely to engage in complicated currency spot and forward trades. But there are experienced portfolio managers out there that can do the job for them.

My two cents are to check out the performance and holdings of international currency hedged mutual funds. The idea behind such funds is to first identify high-quality stocks from around the world. Then, the portfolio manager has to diversify away the currency risk by trading foreign exchange forward contracts through the firm’s corresponding risk arbitrage or hedge accounts.

That way, the adverse effects of foreign exchange rates on the regular mutual fund are offset by arbitrage and hedging activities, at the same time allowing investors the joy of pure returns offered by the underlying stocks in their global mutual funds.