Having just returned from an overseas holiday, I’ve come to accept how far our Canadian dollar goes when travelling abroad. Obviously a stronger Canadian dollar increases our purchasing power in a foreign country and reduces the costs we pay for imported goods, but what does it mean from an investment point of view?
For example, returns realized by a mutual fund that invests in foreign securities are a combination of the security’s price movement and currency movement. If the value of the Canadian dollar increases relative to another currency, investment holdings in that other currency decrease in value. This means that, even though the performance of that fund may be strong in its base currency, the fund could actually decline when expressed in Canadian dollars because of appreciation of the loonie. This has been the case recently with the appreciation of the loonie against the U.S. dollar.
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Broad geographical diversification helps ensure that portfolios have exposure to many currencies, which in turn can help minimize the impact of short-term fluctuations in a single currency. So while a rise in the Canadian dollar may have a negative impact for investors with international investments, the opposite is true when the value of the dollar is low.
Global investments provide not only currency diversification, but access to sectors that are not broadly available in Canada and the potential to earn a greater return by investing in foreign stock and bond markets. While the United States has the world’s largest stock market, more than half of the world’s market capitalization lies outside the U.S., with Canada representing approximately two percent of global markets.
Although the gap is closing, the economies of the world’s various regions still tend to rise and fall in cycles that offset each other.
For example, North American stocks seem to have recovered from the bear market and I feel they are almost trading at fair values. Alternatively, select emerging markets, such as India, are below North American values, which should give investors a better return once they do recover.
What types of international equity investments are available to the investor?
The Canadian mutual fund industry offers a bounty of managed international equity funds that have mandates to invest globally, by country or perhaps by industry.
If you prefer direct exposure to a foreign corporation outside North America, the American depository receipt is one option. ADRs are traded in the American markets just like regular stocks. They are issued by a U.S. bank, consisting of shares of a foreign corporation that are held in custody overseas. This type of security is listed on American stock exchanges.
For the passive investor who wishes to participate in international equity markets but wants to limit the risk associated with investing in a single stock or the selections of a mutual fund manager, the mutual fund industry has created international equity index funds. They are intended to mirror an index such as the Morgan Stanley Composite Index, thereby allowing the investor to “buy the market.”
In general terms, an equity index fund attempts to mirror the performance of a specific market by investing in stocks with a similar weighting found within the underlying index.
This type of index fund isn’t without its flaws because tracking of the underlying index may not be perfect. One consideration that an investor should understand is that in declining markets, equity index funds will not protect capital by increasing its asset mix to cash like an actively managed fund. An equity index fund will remain totally invested in equities and mirror the underlying index decline.
Another investment product for the passive investor is known as exchange traded funds. ETFs are exchange traded securities that represent a basket of stocks that mirror a specific underlying market index. The units are a component of a trust and trade on exchanges at a predetermined fraction of the underlying index.
iShares International Index Funds is one example. It represents a basket of securities that mirrors the total return performance of a specific MSCI market index. Twenty-nine iShares International Index Funds are available with geographic exposure ranging from specific countries to regional indices. For more information I suggest you visit www.ishares.com.
A basic principle of investing is that diversification is a good thing and that global diversification is an even better thing. With the help of your investment adviser, there are a variety of international investment options to provide a starting point on the road to reducing risk through a globally diversified portfolio.
Ian Morrison is an investment adviser with Wood Gundy in Calgary and is licensed to sell insurance products. His views do not necessarily reflect those of CIBC World Markets Inc. or The Western Producer. This article is for information only. Morrison can be reached at 800-332-1407 or by e-mail at Ian.Morrison@cibc.ca.
