Why Buy Foreign Equities?
Foreign equities should be included in a portfolio in order to improve diversification. Canada accounts for only 2-3% of world equity markets. All well-diversified portfolios should contain a significant foreign equity component.
As stated earlier, the FPX Balanced Index is a useful starting point for many investors. To review, this index consists of 25% Canadian equities, 10% U.S. equities, 15% international equities, 40% bonds, and 10% cash. The U.S. equities are held in an ETF based on the Standard and Poor's 500 Index (American Stock Exchange symbol: SPY). The U.S. low-cost indexing fund specialist Vanguard now offers a more diversified ETF, based on the broader Wilshire 5000 index (American Stock Exchange symbol: VTI), as well as one based on the Extended Market Index (American Stock Exchange symbol: VXF) Wilshire 4500 (i.e. the Wilshire 5000 less the S&P 500) that can be used to supplement existing S&P 500 holdings. Both Vanguard and Barclays US offer a variety of US and international ETFs. Barclays Canada offers ETFs based on the S&P 500 (Toronto Stock Exchange symbol: XSP) and the Morgan-Stanley Europe-Australasia-Far East (EAFE) index (Toronto Stock Exchange symbol: XIN). Both XSP and XIN are currency hedged (see below).
Data on many US index funds can be found at Index Funds.
Size and Style Diversification
The variety of index funds available for the US market allows investors to invest in the total market; in large- , small- , or medium-sized companies; in rapidly growing "growth" companies or in inexpensively-priced (but possibly riskier) "value" companies; or in individual industry sectors. A "gummy" tutorial on this approach is below:
As mentioned under the section on asset allocation, one particular type of investing based on academic research by Eugene Fama and Kenneth French holds particular interest. These researchers have found that higher returns can be obtained by investing in either value companies or in small-capitalization companies. These results are called the "Fama-French Three-Factor Model". The broadly-based indexes such as the S&P 500, Russell 1000, Russell 3000, and Wilshire 5000, are dominated by large-capitalization growth companies. The higher return of value or small-capitalization companies is deemed to be due to higher risk. Other observers - Bogle, for example - feel that the long-term returns from the various equity classes will tend to be the same. Nevertheless, it is clear from historical observations that certain asset classes do better in some years than in others. This observation can be used to improve portfolio diversification and along the way to capture any additional return if it is observed.
The simplest option, recommended by Bill Bernstein in "The Intelligent Asset Allocator", is to include both U.S. large-cap and small-cap stocks in the portfolio. One way is to simply divide the U.S. component 50% large cap (S&P 500 or Russell 1000) and 50% small cap (S&P 600 or Russell 2000) components. This article recommends using the S&P 600 for the small-cap allocation rather than the Russell 2000. Since the Wilshire 5000 is about 70% large cap and 30% small cap, a similar 50:50 allocation can be obtained with an asset mix of 70% Wilshire 5000 and 30% U.S. small cap.
A more complex option is the "slice-and-dice" approach favoured by Swedroe (author of "What Wall Street Doesn't Want You to Know") in several Morningstar discussions. This divides the U.S. portfolio into four equal pieces: large cap growth; large cap value; small cap growth; and small cap value. Research suggests this mixture produces a higher return (albeit with slightly higher volatility) than does a total-market portfolio. The approach is summarized in Slice and Dice Primer and In Defense of "Slice and Dice". Although the US proponents use funds not available in Canada, a similar approach can be accomplished by using various Barclays ETFs.
Several alternative mixtures could be used for slice-and-dice; there is no way to predict in advance which mixture would be most effective. Swedroe recommends using the iShares S&P mid cap value ETF - IJJ - for large cap value; see, for example, this conversation. The slices I am currently using are: large cap (Russell 1000, IWB); small cap (S&P 600, IJR); small cap value (Russell 2000 Value, IWN); and mid cap value (S&P 400 midCap Value, IJJ). A similar mix can be achieved by using 35% Wilshire 5000 ( available as VTI), 15% small cap, 25% small cap value, and 25% mid cap value.
Here is the performance of the ETFs:
Individuals wishing to use this approach should be careful to consider the tax implications. Small-cap and value ETFs will have higher capital gains distributions than total-market, large-cap, or large-cap growth slices because stocks can be promoted out. Therefore, put the small-cap and value slices in your RRSP. The total market (Russell 3000 or Wilshire 5000), large-cap (S&P 500 or Russell 1000), or large-cap growth (Russell 1000 growth or S&P 500 Barra Growth) sections can remain in the non-registered account.
The foreign currency exposure associated with foreign equity components may work for or against the investor, depending on the change in value of the Canadian dollar. For many years Canadians who held US-dollar-denominated equities benefited by the long slide in the value of the Canadian dollar. However, the sharp reversal of that slide in March-July 2003 erased the Canadian dollar value of the gains that the US stock market made over that interval. A further discussion of this issue by advisor Dan Hallet is given here.
Professional portfolio managers can use currency futures contracts to reduce or eliminate the effect of currency variations on portfolio performance. This procedure is know as currency hedging. Many professional money managers feel that currency exposure forms part of the diversification advantage offered by foreign equities, and that the costs associated with hedging currency exposure outweigh the benefits. Nevertheless, some investors may wish to hedge currency effects.
Although currency hedging is difficult for small investors to manage directly, some actively-managed mutual funds hedge some or all of their currency exposure.
Investors can check if an index fund or ETF is hedged by graphing its performance versus both the Canadian dollar and US dollar versions of the corresponding index. The Barclays Canada ETFs (XSP and XIN) use currency hedging; if unhedged exposure is desired, similar US ETFs should be used.
Note that caution is necessary when monitoring index fund or ETF performance to ensure that currency effects are accounted for.
Although it is also possible to actively manage currency exposure in an attempt to enhance returns, most individual investors can expect no net benefit from doing so since gains and losses will tend to cancel out and additional fees will have been incurred.
Beware of the hidden cost associated with foreign ETF purchases: the exchange rate spread, which might amount to 1-2% each way - and can easily exceed the brokerage fee. Because of the extra costs associated with ETFs, index funds may be cheaper in some cases, particularly when modest amounts are involved. With larger amounts, consider placing most of the money in ETFs and using a low-cost index fund family for smaller contributions and/or rebalancing.
Canadians purchasing US-based investments for their non-registered account will normally be subject to a 15% withholding tax on US-source dividends (down from 30%). This tax will count as 'foreign tax paid' on your tax return and will be used to calculate a foreign tax credit. US investments held in an RRSP do not have the 15% tax withheld and do not earn a tax credit. Dividends from stocks of non-US companies trading on American exchanges as American Depository Receipts (ADRs) will be subject to withholding tax in accordance with the reciprocal agreement of the company's home country with Canada.
The FPX Balanced Index uses a variety of country-specific ETFs to simulate the Morgan-Stanley Europe-Australasia-Far East (EAFE) index. It is now possible to purchase a single ETF to represent that index, either from Barclays U.S. (American Stock Exchange symbol: EFA), or with a Barclays Canada ETF (Toronto Stock Exchange symbol: XIN, which is currency hedged). Other Barclays U.S. ETFs, carrying slightly higher expense ratios, allow European, Pacific Rim ex Japan, or Latin American regions to be obtained separately. Vanguard ETFs, which have lower expense ratios than the Barclays equivalents, are also available for European (American Stock Exchange symbol: VGK) and Asian (American Stock Exchange symbol: VPL) components. If replication of the EAFE Index by separate European and Asian funds is desired, the European and Asian components should be held in a 70:30 ratio. EAFE growth (New York Stock Exchange symbol: EFG) and value (New York Stock Exchange symbol: EFV) slices are also available from Barclays.
Emerging Markets ETFs are available from Barclays U.S. (American Stock Exchange symbol: EEM, MER 0.75%) and Vanguard (American Stock Exchange symbol: VWO, MER 0.30%). Emerging markets, which are not included in the EAFE Index, are generally considered to have much higher risk than established countries. Nevertheless, an emerging markets component offers not only potential higher returns, but improved diversification because of weak correlation with the S&P 500 and the EAFE indexes. Exposure to emerging markets should be limited to about 10% of the portfolio for aggressive investors, and 3-5% of the total portfolio for conservative investors.
It is possible to "slice and dice" non-US holdings into European, Asian, and emerging market components using Vanguard or Barclays ETFs. In this Morningstar conversation, Rick Ferri indicates that a 40:40:20 European:Pacific:Emerging Market ratio has outperformed a simple EAFE allocation with lower volatility.