The year 2015 was a difficult one for many investors. Canadian stocks returned -8.3%, and bonds, 3.5%. Therefore, investors holding a classic 60% equity / 40% bond portfolio must have suffered a negative return, right? Not necessarily. PWL uses a dozen different strategies to manage risk and enhance portfolio returns. Two of these strategies were especially effective in 2015, helping to produce mainly modest—but positive—returns.
One of these strategies is to diversify the equity portfolio at an international level. In Chart 1 below, the blue bars represent country markets with positive returns, while the red bars depict those with negative returns. As shown, about half the countries had positive returns in 2015.
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The second strategy that worked well is keeping at least some exposure to the currency risk of our foreign equity investments. While it is easy to eliminate, or “hedge,” currency exposure, PWL tends to keep a major portion of it in its portfolios. As depicted in Chart 2 below, the country market returns, once converted from their home currency to the Canadian dollar, were overwhelmingly positive in 2015.
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Why does PWL keep currency exposure in its portfolios? We’re aware that this strategy will not make money every year. In our view, the “right” reasons for keeping currency exposure are related to risk management and cost control. Here are the three main ones:
1. Keeping currency exposure reduces the correlations across markets and enhances the benefits of international diversification, as demonstrated in Table 1 below.
Table 1: Correlation between Canadian Equity and Foreign Markets
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WITH CURRENCY EXPOSURE WITHOUT CURRENCY EXPOSURE
U.S. 0.47 0.71
International Developed 0.56 0.62
International Emerging 0.64 0.72
Source : Morningstar Direct
2. Foreign currency exposure protects our clients’ purchasing power. Most of our clients travel or purchase foreign goods. The cost of being abroad or of buying imported goods fluctuates with the exchange rate between Canada and other countries. When the Canadian dollar weakens, the currency exposure will result in capital gains in our clients’ portfolio, which partly makes up
3. Lastly, hedging currency risk introduces significant ongoing costs. In addition to the trading costs and the higher management fees of currency-hedged funds, less visible costs are often incurred by investors. These costs are explained in detail in this white paper.
Against all expectations, in 2015, a negative return year was turned into a positive one for many PWL clients thanks to global diversification and foreign currency exposure. These strategies were implemented not because we predicted what the markets would do, but rather as sound and enduring risk-management and cost-control measures.
These two strategies will not make money every year. They are not a panacea or a sure-fire strategy for positive returns. Rather, global diversification and foreign currency exposure are part of an array of strategies that, together, help deliver consistent returns over time.