A golden age of Canadian financial exceptionalism is ending.

MARKET VIEW

In recent days, this column has looked at the case for investing more of your money abroad. and at how to prepare a portfolio for a sharp decline in housing. Now, let’s take a look at what investors need to know about currency risk and the use of hedging to contain it.

There’s a growing consensus among forecasters that the Canadian dollar’s decline from close to parity at the beginning of the year has room to run. Capital Economics issued a report this week saying the currency will fall to 93 cents by year’s end, and below 90 cents by the end of 2014. The economics department of a couple of major banks have already issued forecasts that suggest the new normal for the dollar will be in the low 90-cent range, not the near parity of the past few years.

Hedging means using financial instruments called derivatives to screen out the currency impact on investments in securities valued in a foreign currency. Don’t try this at home. Instead, make your call on currency risk by selecting either hedged or unhedged exchange-traded funds or mutual funds.

A falling loonie enhances returns from U.S. holdings for Canadian investors, while a rising currency erodes returns. If your U.S. exposure is hedged, you’re a bystander to all of this. You miss added gains at times such as today, but are protected when the currency soars.

The unhedged approach has a clear edge with investors and money managers right now. At the BMO family of exchange-traded funds, unhedged U.S. equity ETFs are attracting almost twice as much money as hedged funds.

The portfolio managers at Hahn Investment Stewards have decided to keep their U.S. investments unhedged on the rationale that the Canadian dollar is under pressure as a result of this country’s reliance on commodities, which are slumping right now.

“We don’t see anything out there that would indicate any kind of a turnaround,” said Wilfred Hahn, the firm’s chairman and co-chief investment officer. “So, it’s best to stay unhedged.”

Cougar Global Investments is also positioning itself for a weaker dollar. “Therefore, holdings are unhedged in our favourite market, the U.S.,” Susanne Alexandor, a managing director and portfolio manager at the firm, said in an e-mail.

Now for the argument in favour of at least partly hedging your U.S. exposure. It’s based on the idea that Canada’s economy will snap back next year, sending our currency higher.

Camilla Sutton, chief currency strategist at Bank of Nova Scotia, said she expects the dollar to slide further than it already has and then return to parity next year. What’s hurting the dollar now is a wave of negative sentiment that will ultimately subside, she argues.

“The international perspective of Canada is that investors are particular worried about our housing market, and they’re particularly worried about what domestic U.S. oil production means for Canada,” she said. “I would say that for both of those, there’s too much negativity priced in.”

In fact, Ms. Sutton believes that a rising U.S. economy will carry Canada along with it next year by creating demand for our resources, including oil.

This, in turn, would propel our dollar higher, an outcome that would put investors with unhedged U.S. holdings at a disadvantage. Remember, a decline in the Canadian dollar versus its U.S. counterpart adds to your gains in the U.S. stock markets, while a rising currency erodes profits.

Yet, another reason for using hedging is the potential for currency volatility caused by changes in central bank policies on interest rates.

When the U.S. Federal Reserve talked several weeks back about the conditions under which it would start reducing its support for the financial system, the bond market was hit hard. Now, with bond yields rising, U.S. interest rates are starting to surpass Canadian rates. Add that to the list of factors weighing on the Canadian dollar these days.

“One of the things that recent market activity highlights is that as the Fed goes back to normalizing policy rates, they’re re-introducing volatility,” Ms. Sutton said. “What this suggests, if you’re an investor, is that you want to be hedged, or at least partially hedged.”

Hedging gives you peace and quiet on the currency front – you make what your U.S. funds make, without any distortions caused by our dollar. Mind the weaknesses of hedging, though. For one thing, it adds to the cost of owning a fund. Also, hedging is an inexact process that contributes to tracking error, or the gap by which ETFs underperform their respective indexes, even after fees are considered.

The hedged iShares S&P 500 Index Fund (XSP) made 3.2 per cent annually for the five years to May 31, while the S&P 500 made 4.1 per cent. XSP’s management expense ratio is 0.25 per cent, which means tracking error caused in part by currency hedging played a role in the rest of the shortfall.

Over periods of 10 years or longer, many experts believe hedging is unnecessary because currency ups and downs cancel each other out. It’s also thought that hedging isn’t needed when investing in a broad index of international countries, where currency risk is limited by diversification.

However, Ms. Sutton suggests there’s a case right now for hedging some of your international exposure.

Although sinking against the U.S. dollar, our buck is actually doing well against other currencies. “If we wanted to rank currencies, it would be kind of the U.S. dollar first, followed by the Canadian dollar and followed by the rest.”

Mr. Hahn, of Hahn Investment Stewards, said his firm is concerned about Europe’s economic problems and is thus hedging half its exposure to stocks in euro zone countries

“We think Europe is going to be all over the newspaper again before the year is out.”

Find out if funds use hedging

ETF companies are increasingly offering investors a choice of hedged and unhedged funds for U.S. and, to a lesser extent, international indexes. Hedged ETFs typically have something along the lines of “CAD Hedged” as part of their official name. Mutual funds are less transparent about hedging – you may have to dig around a fund company’s website to find the hedging strategy for a particular fund.

Mind the cost

Hedged funds can cost more, but not always. For example, Vanguard charges the same for its TSX-listed hedged and unhedged S&P 500 ETFs.

Partial hedging is okay

Professional money managers often hedge a percentage of their portfolios; with half your U.S. or international exposure hedged, you’re always partly in tune with what the dollar is doing and, thus, more likely to stick to your plan and not sell on a knee-jerk basis.

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick ) and Facebook (robcarrickfinance ).