Hedging the Currency Impact on Canadian Stocks

Canadian investors started the year with a pleasant surprise as the Canadian market and many Canadian stocks performed relatively well. We suggest a little digression to understand the precipitating factors that have driven this rise.
Over the last 6 months, we have seen a dynamic shift in Canadian economics. Canada has been relying heavily on the resource sectors to drive the wealth of the nation. As the resource, particularly the energy sector, plummeted over the last half year, a number of significant concerns were exposed. One only has to look to the Bank of Canada (BoC) and its significant shift in monetary policy to understand the need for immediate action to stabilize the situation. Without going into the specifics, the key observation that must be observed is the divergent monetary policy between the Federal Reserve and the BoC. This divergence has been one of the key drivers in the substantial decline of the Canadian dollar. This currency trend has been significant enough to make a material impact on equity prices in the Canadian market.
In fact, one can attribute much of the rise in the Canadian stock market to the serious decline in the purchasing value of the Canadian dollar. To give a few examples:

Canadian Market:

• iShares MSCI Canada Index Fund ETF (US Dollars) – Year-to-date: -(2.30%)
• ishares S&P/TSX 60 Index ETF (Canadian Dollars) – Year-to-date: +4.50%

BCE:

• BCE shares traded in New York (US Dollars) – Year-to-date: – (3.78%)
• BCE shares traded in Toronto (Canadian Dollars) – Year-to-date: +3.12%

If you are like the average Canadian investor, you are overweight Canadian equities in Canadian dollars and due to the decline in our dollar; we have seen a currency induced/adjusted advance in equities. In order to remain strongly bullish Canadian equities, you have to believe in one of two themes. One, there is a strong economic recovery around the corner for the Canadian economy, or two, the currency will still make a considerable decline towards $0.75 or $0.70 against the U.S. If you are in one of those camps, you can stay long. But if you believe the majority of the currency move is behind us and that the Canadian economy will struggle in the year ahead, this is a great time to employ yield enhancing strategies.
One yield enhancing strategy is to sell out-of-the-money covered calls for a longer duration like 6-12 months. These premiums allow you to create returns without needing further appreciation in the underlying stocks. In addition, the premium received can act as a hedge to reduce the volatility of your portfolio.
As an example, the XIU – iShares S&P/TSX 60 Index ETF, is trading at $22.61. That is over 10% higher off its $20.50 lows in January. An investor that feels there is only marginal upside can sell a September $23.00 covered call is bidding $0.60 or 2.65% cash flow premium.
This is only a good idea for those investors that remain skeptical of the further upside of the Canadian market. At minimum, it is a strategy that could be actively deployed in the upcoming months once the market momentum has started to slow into the historically weak summer months.