Wealth Manager-Currency risks are key in Canadian portfolios

* Diversification helps mitigate currency risk

* Currency neutral funds are simple way to protect

By John McCrank

TORONTO, Sept 10 (Reuters) - Stocks are up and your client is once again beginning to imagine a sunsplashed retirement in Miami Beach in the not-too-distant future.

Not so fast: it's a dream that could fade anew if you fail to take into account the risks posed by the value of the Canadian dollar, advisers warn.

The loonie surged in 2007, collapsed a year later, and has bounced back again this year, highlighting its volatility.

But even if the currency takes a more measured course, your client's golden years may hinge on whether the portfolio has the right amount of geographical diversification.

Special "currency neutral" vehicles that build in risk buffers through currency hedging are also an option, though they can have their own drawbacks.

Brent Woyat, portfolio manager of OceanForest Investment Partners at Raymond James Ltd in Vancouver, said he makes sure his clients have well-diversified portfolios with exposure to quality U.S. and European equities and bonds. He even recommends selected names from emerging markets.

"A good adviser will adjust the exposure to different markets and currencies in the portfolio to reflect the age of the clients, their ability to withstand a market shock, and where they spend most of their time," he said.

A lot depends on how much of a Canadian's investments are weighted toward the United States, and how much of your client's nest egg will get spent in sunny Florida or Arizona.

As world stocks have rebounded in recent months, the Canadian currency has followed suit, with the prospects for a global economic recovery brightening and the price of oil, Canada's lifeblood, rising in kind.

For many of your clients, the stronger loonie may have canceled out fatter returns on equity priced in U.S. dollars.

For "snowbirds" flying south for the winter, the stronger loonie buys more in Phoenix, but what happens when the greenback rebounds?

TWO INVESTMENTS IN ONE

It's important to remember that when Canadians purchase any foreign investment, they're actually making two investments: the asset itself and the currency, said Camilla Sutton, a financial analyst and currency strategist at Scotia Capital.

"Accordingly, any foreign investment should take the currency component as a real part of the decision-making process," she said.

On a year-to-date basis, the Canadian dollar is up 13 percent. In the United States, the S&P 500 is also up 13 percent, which means a Canadian who invested in the S&P on Dec. 31 has achieved a return of zero percent as the currency component offsets the equity gain.

Sutton said a simple way to remove currency exposure from a portfolio is to invest in "currency neutral funds." They provide exposure to U.S. equities while easing day-to-day worries over the U.S. dollar through hedging.

"For those who are not seeking the added risk of currency exposure, these funds provide an easy and relatively inexpensive way to hedge themselves," she said.

LESS THAN PERFECT

While currency-neutral index funds and mutual funds strip out the lion's share of the currency risk, they're not perfect, because currency hedging is a complicated process, Woyat said.

Back in November, during the market meltdown, the selloff in equity markets was offset by a rally in the U.S. dollar as investors sought the safety of the world's principal currency.

"So investors holding unhedged U.S. equities in a Registered Retirement Savings Plan (RRSP) noticed that these investments weren't dropping nearly as much in Canadian dollar terms as their comparable Canadian investments," he said.

Investors who had currency-neutral U.S. investments in their RRSP, without exposure to the rising U.S. dollar, took the same drastic losses as any U.S. investor.

So currency neutral funds aren't perfect, as they take away potential gains when the U.S. dollar rises and then is converted back into Canadian dollars. But this year, with the loonie making gains, those in currency neutral funds are seeing rewards.

Woyat said currency neutral funds are best suited to someone who already holds U.S. investments in a U.S. dollar investment account. Or perhaps an investor is inclined to have a U.S. account, but the amounts aren't big enough to justify the transaction costs associated with trading individual securities.

Even for those who do most of their spending in Canadian dollars, Woyat said it still makes sense to hedge the global portion of their investments to minimize the effects of currency swings.

($1=$1.08 Canadian) (Reporting by John McCrank; Editing by Frank McGurty and Peter Galloway