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By Jonathan Chevreau
National Post
FP Weekend Section
Saturday, February 26, 2005 |
Suddenly the world is our oyster, now Ottawa has announced its intention to scrap the 30% foreign content limit.
Adrian Mastracci, investment counsel at Vancouver’s ‘fee-only’ KCM Wealth Management, says, "Look before you leap is my view of the foreign landscape. Too many investors put the selection of investments far ahead of the policies and strategies they ought to be pursuing to get to their destinations.”
Following the unexpected announcement in Wednesday's federal budget, financial advisors across the country are setting up meetings with clients to discuss how to take advantage of the change.
Uppermost in their talks will be the fact the law first must be officially changed. When the government announces any tax change that takes effect immediately, Canada Revenue Agency administers the law on the basis of proposed tax changes even before the legislation passes, says Louis Levesque, associate deputy minister for the Department of Finance. Assuming Parliament approves the change, investors who have increased their foreign property holdings above 30% any time after budget day will face no penalties, Levesque says.
So keeping in mind this caveat, if you're a mutual fund investor you can now dump high-cost foreign clone funds for slightly lower-cost direct-exposure global equity funds from the same fund family.
But as the accompanying table shows, you can go one better and leave mutual funds altogether and invest in global exchange-traded funds (ETFs) like the Dow Jones Global Titans.
If you prefer to invest in individual stocks, you can now swap Nortel Networks for Cisco Systems, Cognos for Microsoft and even switch Canadian bank stocks for American banking giants.
You can also broaden your exposure to fill sector gaps in the Canadian market, which is essentially rocks, trees and banks. If you've been underweight consumer products giants like Johnson & Johnson or pharmaceutical behemoths like Merck or Pfizer, you can now rectify the situation.
When you consider Canada accounts for only 3% of the world's capital markets, the requirement that pension funds and RRSPs hold 70% Canadian content was a gross distortion of proper portfolio construction principles.
Canadian investors paid for this constraint with underperformance. Advisor John De Goey says U.S. stocks have outperformed Canadian stocks by 2% a year.
The mutual fund industry realized this, which is why many actively managed Canadian equity funds boosted performance by including U.S. or foreign stocks within the 30% foreign content permitted even for Canadian equity or balanced funds.
"They tried to fob that off as superior security selection when in fact it was the portfolio management equivalent of steroid doping," says De Goey.
De Goey prefers "pure" asset classes: Canadian equity funds that are 100% Canadian, or U.S. equity funds that are 100% U.S., etc. Then when it comes time to construct a properly diversified portfolio, you don't have to account for style impurities. That's one reason why De Goey likes enhanced index funds from firms like Dimensional Fund Advisors Canada Ltd.
Patrick McKeough, publisher of the Wall Street Forecaster, says Canadians are still motivated to buy Canadian stocks in their non-registered portfolios. That's because they qualify for the dividend tax credit. Dividends from U.S. or foreign stocks are taxed like interest income, while Canadian dividend income gets better tax treatment. (There is withholding tax on U.S. dividends but you get it back on your tax returns.)
If anything, the removal of the 30% limit could result in a dramatic new way of optimizing the tax treatment of investments across registered and non-registered portfolios. Under the old regime, the optimal tax-effective strategy was to put Canadian stocks and bonds inside an RRSP and foreign stocks outside.
Now, there's a case for reversing that: putting foreign stocks or funds inside RRSPs where the dividend income won't be taxed like interest, and putting Canadian dividend-paying stocks outside RRSPs.
"Look before you leap is my view of the foreign landscape," says Vancouver fee-only advisor Adrian Mastracci at KCM Wealth Management, "Too many investors put the selection of investments far ahead of the policies and strategies they ought to be pursuing to get to their destinations."
McKeough also warns against going overboard in stocks outside North America. He feels U.S. multinationals provide all the global exposure Canadians need.
The first priority is for Canadians to fill out the U.S. sectors which are underserved in Canada: health, pharmaceuticals and consumer stocks among them. McKeough likes stocks like Beckman Coulter but warns U.S. drug giants carry more risk. Some U.S. stocks also provide Canadian exposure -- a good example is fast-food chain Wendy's International, which owns Tim Horton's.
Even economic sectors where Canadians are well exposed -- notably financial services -- can be diversified by adding stocks like MBNA Corp., McKeough says.
Smart investors can now buy "real health care stocks" in the U.S., says advisor Nathan Mechanic. But you still need to consider currencies, he adds. Since most investors plan to retire in Canada, they will want to have far more Canadian exposure than the 3% our global weighting would suggest.
If you're a balanced investor with an equal mix of stocks and bonds, you probably won't need much more than the 30% foreign content exposure you were previously permitted.
If 50% is in fixed income, you would have had 30% foreign equity and 20% Canadian equity, which is about right. Furthermore, many Canadians had additional foreign exposure through their non-registered portfolios, which have never been constrained on foreign content.
On the other hand, because of their long time horizons, the country's pension funds can be expected to move to 50% foreign content, says McKeough.
Because they are familiar with local names and often work for them, average Canadian retail investors will always be overweight our own securities, whether the government mandates it or not. Most developed markets have a "home market bias."
The Investment Funds Institute of Canada once commissioned a study to see how much foreign content investors in other countries chose when they were not constrained by government mandates. British investors, for example, tended to max out at about 30% to 35% foreign content.
The person who did that study was Keith Ambachtsheer, president of KPA Advisory Services Ltd. of Toronto. "The biggest thing here is Ottawa has finally signalled we are a developed economy and doesn't need to protect local industry and is open for business."
What a concept: invest in Canadian securities purely on their merits.
It's about time.
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