How much foreign content should your portfolio hold?

How much foreign content you choose to hold in your portfolio should depend on your investment objectives, time horizon and risk tolerance. But when you calculate your foreign content, remember that some of your Canadian equity funds may hold foreign content too.

In recent years, there has been an increasing correlation in the performance of stock markets around the world. This has reduced some of the risk-reduction benefits of foreign diversification. Yet there are other risks to consider when you diversify internationally as well.

Chief among them are currency, political and regulatory risks. Canadian investors who have held unhedged European equity funds this year should take note of currency risk. The Euro Stoxx 50 Index has gained 1.8 per cent since the beginning of the year. But, over the same period, the Canadian dollar has lost 2.9 per cent of its value against the euro. So, in Canadian dollar terms, the Euro Stoxx is down 1.2 per cent year to date.

Of course, currency fluctuations may cut both ways. The S&P 500, the large-cap index in the U.S., has gained 9.2 per cent year to date. But the U.S. dollar has gained 6.9 per cent against the Canadian dollar over this time. So in Canadian-dollar terms, the S&P 500 is up 16.7 per cent year to date.

Changes in governments and their policies, meanwhile, can also influence your foreign investments. This has been historically true of emerging markets, where political instability and corruption tend to be more common.

On the other hand, there are few who would argue that you should not bother with foreign diversification. After all, when you invest in the U.S. or abroad, you get access to investment opportunities that simply don’t exist, or exist in limited form, in this country.

How much risk should you take?

The risks involved in foreign investing raise a very important question for all investors: How much foreign content should you have in your investment portfolio?

The answer to that question, of course, depends on your investment objectives, time horizon and risk tolerance. But we would venture to suggest that most investors with a growth objective and a time horizon of about five to 10 years or more would probably be best off putting about half their portfolio in foreign investments.

But remember, when calculating your foreign content, some of your Canadian stock funds may also have considerable exposure to international stock markets. Such funds are categorized as “Canadian focused equity” funds by the Canadian Investments Funds Standards Committee. They hold more than 10 per cent, but less than 50 per cent, of their assets in foreign securities. CI Canadian Investment, CI Harbour, Mac Ivy Canadian and NEI Northwest Canadian Equity are examples of such funds.

Registered-account funds

There are, of course, a number of ways you may add foreign exposure to your investment portfolio. One of these is through index funds that hedge their exposure to foreign currency fluctuations — a feature that’s meant to reduce foreign currency risk.

But take care when you invest in funds such as these. Take RBC International Index Currency Neutral Fund, for example. To track the MSCI Europe, Australasia and Far East Index, this fund invests primarily in Government of Canada treasury bills and other Canadian money-market securities as well as derivatives, such as options, futures and forward contracts.

Consequently, the fund’s capital gains are taxed as ordinary income, not as capital gains. And since ordinary income receives less favorable tax treatment than capital gains, the fund, according to its prospectus, is designed primarily for registered tax deferred plans such as RRSPs, TFSAs and RRIFs.

If you’re investing in an index fund that uses derivatives to track an index, then, remember to check its prospectus to see if there are any tax consequences of the fund’s strategy.

 

Canadian Mutual Fund Adviser, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846