Tuesday, January 14, 2014

Currency Exposure is Partly an Illusion

When Canadians own U.S. assets, they usually think they are exposed to U.S. dollar fluctuations. This is only partly true. Our tendency to think of dollars as an absolute measure of value muddies the water.

Let’s choose a very simple fictitious example to help illustrate these ideas. Sandy bought 100 shares of a U.S. stock ETF trading at US$100 per share at the start of a year when the Canadian and U.S. dollars were at parity. So, her investment started out with a value of C$10,000.

By the end of the year, the ETF shares rose in value to US$120, and the U.S. dollar finished the year worth C$1.10. Sandy’s 100 shares are now worth US$12,000, or C$13,200. We would normally say that the ETF rose 20%, and Sandy made an extra 10% on the U.S. dollar for a total (compounded) return of 32% when measured in Canadian dollars.

Based on this example, it appears that Sandy’s investment had full exposure to the relative value of U.S. and Canadian dollars, but this isn’t the case. Her real exposure is only partial. This becomes clear when we shake off the notion that dollars are an absolute measure of value.

We need to look at what happened as the U.S. dollar rose relative to the Canadian dollar. Suppose the reason for this change was that the U.S. dollar rose against most of the world’s currencies. This means that some of the U.S. businesses owned by the ETF saw the value of their foreign revenues drop when measured in U.S. dollars. They also saw the value of some of their foreign assets fall in value. If the U.S. dollar hadn’t dropped, some U.S. businesses would have had higher revenues and asset values when measured in U.S. dollars. This means some of the stock prices would have been higher (again measured in U.S. dollars). So, if the U.S. dollar hadn’t risen, perhaps the ETF return would have been 23% instead of 20%. The net effect of all this is that Sandy’s exposure to the U.S. dollar was only partial.

It’s important to remember that when you buy stocks, you own slices of businesses, not dollars. Changes in the value of U.S. dollars do not translate 100% into the same changes in the value of U.S. businesses. This may seem to be the case over the short-term, but over the long-term, businesses have a complex set of exposures to the currencies of the world.

This lesson becomes even clearer when we look at an ETF such as VXUS which is bought and sold in U.S. dollars, but holds stocks of non-U.S. companies. It makes little sense to believe that the value of VXUS has a 100% exposure to the U.S. dollar just because it is traded in U.S. dollars.

Understanding all this, Canadian Couch Potato’s explanation of how a falling Canadian dollar affects U.S. equity ETFs makes perfect sense. Whether your ETF of U.S. stocks is traded in Canadian or U.S. dollars, what you own is a slice of a set of businesses, and your currency exposure is exactly the same in each case (unless the Canadian version includes currency hedging).

If we can’t use dollars as an absolute measure of value, what can we use? The best answer for most Canadians is to use the Consumer Price Index (CPI). This is basically the Canadian dollar adjusted for inflation in the prices of a basket of goods most of us need to buy. For Canadians who spend a lot of time in the U.S., some blend of inflation-adjusted Canadian and U.S. dollars would make sense.

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