Though the Canadian market makes up just 3.6% of the World stock markets, Canadian investors are justified in being overweight in our stock market for the following reasons:

  1. A Canadian investor who is saving for her retirement in Canada needs to fund her liabilities in Canadian dollars and having too much exposure to foreign markets introduces foreign exchange risk. Since valuations among developed markets are comparable and earnings growth in these markets is similar, the expected returns from Canadian stocks isn’t materially different from other developed countries. Therefore, the purpose of foreign stocks in a Canadian investor’s portfolio is diversification. One study by money manager Leith Wheeler found that Canadians can get most of the benefits of diversification by allocation 50% of their stock portfolio to overseas markets. Some could reasonably argue that the 70% allocation to foreign markets in the stock portion of the Sleepy Portfolio is too much, not too little.
  2. In taxable accounts, eligible dividends paid by Canadian stocks receive favourable tax treatment. Assuming a 2.5% yield, investors in some tax brackets may find that more than 40% is lost to taxes for international stocks but only 20% in the case of Canadian stocks. Over the long term, all things being equal, a Canadian investor will earn greater after-tax returns with Canadian stocks than international stocks.
  3. Canadian investors capturing exposure to global markets through ETFs listed in the US stock markets will experience additional leakage through withholding taxes. These taxes add to the cost of foreign investments and act as a drag on a portfolio return.

What’s your take? Is the 70% allocation to US, EAFE and International stocks in the Sleepy Portfolio too much diversification? Or is it too little, considering Canada makes up less than 4% of global markets?

PS: Spring has sprung and this weekend promises fine weather for an Easter Egg Hunt and just hanging out on the patio. Hope everyone has a great Easter weekend.

This article has 30 comments

  1. My portfolio is overweight Canadian stocks/ETFs, primarily because of the tax reasons you mention. I do own some foreign stocks/ETFs in sectors that aren’t well represented in Canada, like healthcare and consumer discretionary.

  2. I don’t have a set allocation target, but my stock portfolio is roughly 50% CDN and 50% US stocks. That seems reasonable to me, since the US market is so much bigger, and would reasonably be expected to have more opportunities. This offsets some of the currency risks and tax disadvantages.

    I don’t see a lot of reason to diversify outside of Canada and the US, since I’m a stock picker, and there’s only so much research I want to do. Besides that, my brokers are focused on providing trading for Canadian and US exchanges. I imagine it would be more difficult to buy individual securities on other exchanges, say Hong Kong or London. They would also have different regulations and accounting standards, and I’m not interested in researching that.

  3. It could be said that if you’re too heavily weighted in Canada, you’re more than likely heavily weighted in Resources and Financials, which isn’t very diversified and almost unknowingly makes it a speculation play. When viewed in this context, maybe the 30-70 split isn’t such a bad idea afterall – maybe even 20-80 or 25-75 would be better.

  4. I’m 18% CAD equities, 36% US, the rest are international. Maybe I should overweight CAD more…

  5. Hello Canadian Investors,

    What’s your take for the coming fall out for the next 6 months?

  6. I feel more comfortable increasing exposure to foreign equities when the loonie is strong and has greater purchasing power, e.g. near or above parity to the US dollar. I don’t like to do it so much when the loonie is weak, e.g. near $0.70 (U.S.).

  7. My RRSP’s equity component is split roughly evenly between Canadian equities, US equities and International equities through a series of low-cost index funds. I guess that makes my portfolio overweight Canada. I’m okay with that though. My return on Canadian equities should be higher than my return on US and International equities because the dividends are not subject to withholding taxes.

  8. I’m roughly 1/3 Canadian ETFs, 1/3 US ETFs, 1/3 global ETFs. About 1/2 of the non-Canadian ETFs are hedged, 1/2 non-hedged. With the Loonie on a run, I’m planning to sell the hedged ETFs and buy similar unhedged ETFs in US dollars (likely all from Vanguard).

  9. Depends what you mean by “diversification”. Remember you are superimposing currency risk onto market risk. By the way, If Canada is only 4% of capital markets, does this mean we should put 20% in Japan? What was your best country to invest in March 2009? Happy Easter to all!

  10. Good point by E. If you’re over-weighted in Canadian equities, you’re likely over-weight in financials and resources as well.

  11. This idea of funding Cdn $ liabilities with Cdn $ assets is fine in theory, but a) most retiring Canadians will have a huge Cdn $ asset – their house, by then free and clear – already, b) may receive government benefits and/or pensions in Cdn $ anyway to cover much of their nondiscretionary Cdn $ expenses, and c) discretionary travel and consumer goods may be paid in Cdn $ but are essentially priced to track US$. So your Cdn $ asset-liablity mismatch may be a lot less than it appears at first glance.

  12. Canadian Capitalist

    @gene: If I invested in individual stocks, I wouldn’t go to the trouble of investing in the UK or Hong Kong exchanges either. There is plenty of fish available in the Canadian and US stock exchanges to go fishing in exotic locales.

    @E: That’s a very good point. XIU has 34% in Financials, 26% in Energy and 18% in materials. That’s close to 80% allocation to just two sectors: financials and resources. Indexed investors have a very good reason to put a significant chunk in overseas markets.

    @Larry: I agree. With the loonie strong and the Euro weak, this may be a good time to pick up EAFE stocks. In any case, I’m finding EAFE allocations to be below target anyways, so that’s where new money is heading.

    @Houska: Good point. Also, Canadian investors likely have their bond portion in Canadian dollars. Typically, older investors tend to keep more of their portfolio in bonds anyway, so a significant chunk of the portfolio will be denominated in Canadian dollars.

  13. — Canadian investors capturing exposure to global markets through ETFs listed in the US stock markets will experience additional leakage through withholding taxes. —

    Is this the case for RRSP accounts as well? I thought it was only non-registered accounts that got affected by this

  14. I’m a stock picker as well. I have a US brokerage account that represents 1/3 of my total portfolio. My Canadian portfolio makes up the remaining 2/3 of the total.

    I have to make the point that just because all of my stocks are listed in either Toronto or New York / NASDAQ, that doesn’t mean that I don’t have international exposure. Many of the companies for whom I own shares are multi-nationals. In fact, I’d almost have to say that most (more than 50%) of the companies I own fall into that category.

  15. To answer your question, yes, I believe it’s too much. Here are two reasons. 1) Canada has pretty much what everyone else wants; forestry, oil, natural gas, metals, water and a sound financial sector to glue it all together. We have every bit of upside, even if its only moderately managed, for the next two generations… 2) I would assume you plan to retire in Canada and to that end, invest in those companies you understand, know and trust. While I certainly support investing in China, Japan, India and the US; its a wise move for sure to be diversified, I’m not convinced international markets should make up the majority of any portfolio. I would probably max out at 50%, if that. All the best CC, good post!

  16. I don’t care if Canada = 0% of the world stock market. When one invests outside of Canada, no matter how diversified they think they are all non-Canadian investments are exposed to a single risk factor – an appreciating Canadian dollar.

    Also, the ‘studies’ that show that over a 25-30yr time period currency hedging is a wash are bogus. You get on the wrong side of a 10yr currency move and you’re either a hero or toast.

  17. Just for clarification for me, are dividends from Canadian ETFs taxed at a preferred rate, the same as Canadian company stock dividend?
    SO when I get a diividend from XCB, CDZ, XIU, XSP, (all invested in Canadian companies), that amount can be declared as a Canadian dividend, and get preferred tax treatment?
    What about XSP (iShares CDN S&P500 Hedged)?
    If we get a dividend posted to our online brokerage account, do we automatically recive a T-4 or T-5 for the dividends received, or is that something we have to figure out ourselves like the capital gain/loss amounts.?
    Thanks, I appreciate your posts and help.
    Pacific

  18. A commitment to the Canadian market is largely a commitment to commodities and financials, with a small dose of techs… Canadian investors can make significant returns in these markets… let’s not forget, Canadian companies are selling internationally in some cases, so how Canadian are they?

  19. Pacific: For ETFs of Canadian stocks, you do get preferred stock treatment. Keep in mind that at least CDZ produces its “dividend” as a combination of interest, canadian dividends, and return of capital all of which would be taxed differently. Details are on their website.

    Dividends from XSP would be a “foreign dividend” and be taxed at your MTR. Furthermore, there would be unrecoverable withholding tax on the US side that would drag the dividend down even more.

  20. I started investing in 86,didn’t start good record keeping until 89…the past 5,10,15 years Canada was the best market ….pass 20 years not so…

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  22. In my opinion, 70% is way too much. From a tax perspective, as well as the exposure to currency changes as you mention, a significantly high percentage allocation in foreign investments does not interest me. From an equity standpoint, my target allocation is to have about 10% of my equity investments in foreign content. However, with that being said, I’ve also been researching index funds to add more diversity and foreign exposure within my portfolio.

  23. doctor stock touched on something i wonder about and that is what is Canadian & what is International, Mcdonalds is an American company but doesn’t it sell it’s products worldwide? Bombardier or RIM are Canadian but do they sell only in Canada? no of course not, in this day & age where products or items that years ago could only be had locally are now worldwide do we worry too much about global diversification in our holdings?

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  25. Exactly Rick… a more important issue is currency as you invest either in companies that sell internationally or are only traded on international exchanges.

  26. I agree with “the Rat” that 70% is too much if retirement date is within the next 5/7 years. Perhaps it would be worth the risk if the time span to retirement is a minimum of 10/12 years? 50/50 is more my cup of tea. However, I am still undecided as to the weighting of Canadian stocks/ETF’s in the portfolio? Now that the Canadian dollar is virtually at par, doesn’t it make sense to perhaps dump any hedged U.S. ETF’s and buy them direct [Vanguard]?. Surely, any withholding tax exposure would be off set by the much cheaper MER’s? I would be interested in suggestions/comments.

  27. The preferential tax treatment for dividends from Canadian stock should be dumped at the next possible chance. It’s an anachronistic distortion of the allocation decision of Canadian investors. Canadians should be free to invest where they want without the government distorting their stock picking decisions.

    That said, in the recovery the Canadian market with its heavy commodity bias will do better than the US or European markets, and so will the Loonie. No more than 30% internationally, most of it in BRIC.

  28. 70% foreign allocation is a bit too much. 10 – 30% is usually appropriate given all the negatives (costs, triple taxation, currency fluctuations, etc). Mostly in Emerging Markets and/or BRIC but not EAFE. Many developed country indexes have heavy financial weightings anyway so you’d have to invest in individual companies there.

  29. Lots of great discussion. Struggling with this myself as I move from a very confusing Mutual Fund Portfolio to an ETF/Index Fund Portfolio. I must say that I am trapped by trying to find the Optimal Asset Allocation.

    Still deliberating but will likely go 10% US and 10%Foreign 40% Canadian for Equity

    Unfortuantely the correlation between Canada and World Equity Markets is so high that the the diversification might not reduce risks or increase returns

    H

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