Why foreign content and how much should you have?

Over the last 20 years, international markets have outperformed Canadian markets by almost 2% a year.  It makes sense to invest globally not only based on historical returns, but also because many economic sectors (eg. Healthcare) are not significantly represented in Canadian markets.  In addition, despite several good years recently, Canada only represents 3% of world stock markets.

However, investing globally is higher risk, partially due to currency fluctuations.  So the lowest risk blend of foreign to Canadian for the equity portion of your portfolio is 40%/60%, but for most clients, a 50%/50% split will provide the best risk/return tradeoff.

Minimizing risk and financial theory are fine.  But what are professional money managers doing?  Canadian Pension plans in fact have the majority of their equities outside of Canada.  This matter was reviewed in detail in a recent ScotiaMcLeod Exchange newsletter.

Similarly, we profiled the asset allocation of the Scotiabank pension plan in a recent newsletter article, and found that it is 39% Canadian equity and 37% foreign.

We would be pleased to review your foreign content (including the foreign holdings in your Canadian funds) in our comprehensive Asset Allocation review. Please contact mailto:carl_spiess@scotiamcleod.com for a review.

Budget Update Summer 2005:

As of July, 2005, the federal budget changes, outlined below, have been passed into legislation. Fund companies will have phased out the RRSP Clone funds by fall of 2005. The following information is maintained for historical reference only.

Budget Update 2005:

As of February 23, 2005, the foreign content limit for RRSPs has been eliminated.  The budget eliminates the need for foreign content clone funds described below, and for ongoing monitoring of the foreign content limit.  We would expect that it will take a little time for the budget to be passed, for RRSP statements to be updated, and for decisions on the best way to merge/transfer the clone funds into the regular versions of foreign funds.   We continue to recommend a balanced approach to investing, with bonds, and Canadian and International equities diversifying a portfolio based on your investment goals and risk tolerance.

Historical Background: What are 100% RRSP Eligible Foreign Funds?

For many years Canadian investors had lobbied the Federal Government to increase the foreign content room in personal RRSP accounts and corporate pension plans above old limit of 20%. Finally, the 2000 budget increased the level to 25% and to 30% in 2001. There are good reasons for this increase. In the chart shown, global investments have historically delivered higher returns than Canadian Funds. By combining international with Canadian investments, you can potentially increase your returns with lower risk.

The Canadian mutual fund industry showed great innovation during 1999 and created global funds that still qualify as 100% Canadian content. It is now possible to have your RRSP account with 100% exposure to global investments. (Although we would still recommend a balanced portfolio.)  While most funds are new, C.I. has offered their C.I. Global Equity RRSP fund since 1993, and the Mutual Fund Reporter recommended that fund in September 1993, issue 81 (.pdf 120k), back when RRSP foreign limits were only 18%!

Here's how it works. The fund company offers a Canadian fund, which is a clone to their global fund. For example, Templeton's International Stock Fund, which is eligible for RRSP accounts up to a maximum of 30%, may now be purchased as the International Stock RSP Fund, which is 100% RRSP eligible. Similarly, Fidelity's International Portfolio Fund (30% RRSP eligible) may now be purchased as Fidelity International RSP Fund, which is 100% RRSP eligible. 

In simplified form, the funds invest 90% of their assets in T-bills, and 10% into investments that are 10x as volatile as the underlying funds. The 90% makes it RRSP eligible, and the 10% which is volatile, then drives the total portfolio up or down to match the performance of the original fund.

There is an increased cost to the management expenses (MER's) for this feature and all cloned funds will experience returns, which are lower by an average of .4% per year compared to the parent fund. Historical returns may justify this slight increase compared to the returns of the average Canadian fund, but this strategy does add risk.

One note of caution: for tax purposes, increases in the value of clone funds qualify as income instead of capital gains. You should therefore only purchase and hold these funds inside an RRSP account where all growth is tax-deferred.

Labour Sponsored Funds and CCPC shares also Increase Foreign Content

Labour Sponsored Venture Capital Funds or CCPC shares inside your RRSP increase the allowable foreign content in your plan by three times the amount of your investment, up to a maximum of 50% beyond the regular 30% limit.

For example, if you invest $5,000 of your RRSP in a labour fund, you can have up to an extra $15,000 in foreign investments, as long as the total of your foreign investments' book value doesn't exceed 50% of your RRSP’s book value.

Other Ways to Increase Foreign Content

Finally, we can purchase for your account, Canadian government bonds issued in foreign denominations.