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Time is right to boost foreign content in your RRSP

by Wayne Cheveldayoff, 2004-02-12

Those with foreign investments in their RRSPs can be forgiven for feeling burnt by the sharp rise of the Canadian dollar in 2003.

At a time when the U.S. and many other foreign stock markets were booming, the effective returns to Canadian investors holding foreign funds were meagre.

While each fund showed a different return, the currency impact can be illustrated by comparing the performance of the U.S. Dow Jones Industrial Average (DJIA) in Canadian and U.S. dollars.

For 2003, the DJIA was up 28.3 per cent in U.S. dollar terms. But in Canadian dollar terms, it was up only 5.9 per cent.

By contrast, those investing in Canadian stocks did better. The S&P/TSX Composite Index rose by 26.7 per cent in 2003.

However, this should not discourage RRSP investors from having foreign content in their RRSPs.

There are a lot of good reasons for having foreign content, including a lowering of risk through diversification and access to high-growth sectors like technology and pharmaceuticals that are poorly represented in Canada.

Those with foreign content did exceptionally well prior to 2003 from capturing higher returns abroad. This, of course, was augmented by currency movements when the Canadian dollar was in a declining trend.

In fact, this is probably a better time to add foreign content than in any of the past five years when the Canadian dollar was undervalued.

There is now little risk of the Canadian dollar surging ahead for a second straight year. The dollar is no longer undervalued. It has already reached a level where exporters are hurting, manufacturing companies are considering moves to other countries and the Bank of Canada has subtly indicated it would lower interest rates rather than see the dollar escalate much beyond 80 cents (U.S.).

Another sharp move upward of 10 or 20 per cent in the exchange rate would kill the Canadian economy. And if that happens, you wouldn’t want to own Canadian stocks anyway.

What is the right mix of domestic and foreign content in an RRSP? Long-run returns for foreign, particularly U.S., equities have historically been higher than for Canadian equities, so history says more foreign is better.

Government rules stipulate a maximum of 30 per cent (to keep the bulk of pension money in Canada). However, with currency risk low and given the opportunities for better returns abroad, at least 50 per cent foreign seems more appropriate on a risk-return basis.

For those involved in mutual funds, there are several ways of getting foreign content above the stated 30 per cent maximum.

If an investor puts 30 per cent of a portfolio in foreign funds and the remaining 70 per cent in domestic funds that routinely maximize their foreign content, he or she will have as much as 51 per cent foreign exposure.

Through another route – using “clone” funds or RRSP-eligible international index funds – RRSP investors can actually have 100 per cent foreign content if they wish.

Clone funds are structured to mimic the returns of actively managed foreign funds. Clone fund managers generally invest most of their funds in Canadian short-term securities such as treasury bills, thereby ensuring Canadian status, and at the same time they buy customized futures contracts from financial institutions to produce the return of the fund they are trying to mimic. The derivatives usually add 0.4 to 0.6 per cent to the underlying fund’s management expense ratio (MER).

RRSP-eligible international index funds track the returns of a foreign index, such as the S&P 500 in the United States, by investing (like clone funds) most of their money in Canadian short-term securities such as treasury bills and the balance in derivatives that cause the fund to mimic the movement of the index. Because there is little portfolio management involved in index funds, their MERs are usually lower than clone funds.

Investors may want to check the fine print on derivative-dependent funds for the impact of currency moves. The performance of some of these funds is not affected by swings in the Canadian dollar exchange rate.

A third way of boosting foreign content in an RRSP is to invest in Labour Sponsored Investment Funds (LSIFs). For every $1 invested in LSIFs, an investor can boost foreign content by $3, up to a maximum of 50 per cent total foreign content.

For example, an RRSP with a book value of $60,000 would normally be allowed $18,000 foreign content (30 per cent of $60,000). All it would take is a $4,000 investment in an LSIF to allow foreign content to be increased by $12,000 to $30,000, or 50 per cent of book value.

Almost all LSIFs qualify for this kind of treatment (they must be small business corporations) but a few don’t, so it would be wise to check for sure if you want to take advantage of this method of boosting foreign content in an RRSP.

In choosing foreign funds, investors should have a large concentration of funds focused on the U.S. economy, which has proven again and again to be the most technologically advanced and vibrant economy in the world.

Beyond that, it would be wise to avoid overseas country or area specific funds. It is better to stick with international funds where the managers can go anywhere in the world to seek out the best opportunities.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.

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©2004 Wayne Cheveldayoff