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Foreign Asset Allocation in your RRSP


Foreign Asset Allocation in your RRSP

Contributed by: martingale

Investing How much money should you invest in foreign markets? A recent study in the Journal of Finance examined the extent to which mutual fund investors tend to put their money in their home country. This is called domestic bias. In every country, investors are biased towards investing in their own country. In this article we'll look at the market capitalization of global markets, and discuss how much money you should invest overseas. Given that the Federal Govt. just eliminated the foreign content restrictions in RRSP's, it's a good time to review your global asset allocation!

The Canadian stock market represents 2.99% of the global stock market, yet Canadians overwhelmingly invest in Canada. All other things being equal, you should invest in securities in proportion to their market capitalization. Applied to national stock markets, that would mean that you should hold not more than 3% of your net investments in Canadian equities. The table below shows the market capitalization of the worlds largest stock markets, expressed as a percentage of the global equity market. It shows that the United States represents 46.86% of the world market, while the Canadian stock market represents 2.99% of global equities.

The second column is a measure of how biased mutual fund investors in each nation are towards their home market, and represents the amount of domestic over-investment versus their nations share of the global market. Greek investors are the worst-over investors (5.35) while Americans are the best at spreading their money proportionally around the globe (0.61). Canada, at 2.41, is not the worst offender. (For the mathematically inclined this value is a logarithm of the ratio.)

The study by Chan, Covig, and NG in the June 2005 issue of the Journal of Finance concluded that mutual fund investors in all countries over-invest in their home market, and that the two factors that matter most are how developed the local economy is, and how remote it is from other countries geographically, culturally, or linguistically. It seems to me that the first of these is sound thinking--your money will be safer, and it'll cost less, if you invest in a highly developed economy, so it is sensible to invest more. The second factor, linguistic and cultural remoteness, seems unlikely to be well correlated with your long-term returns. In other words, not all of that over-investment at home is justified.

It is the view of this magazine that you should structure your global equity investments roughly in proportion with market capitalization, and so the table below can be used as a rough guide to breaking foreign asset allocation. It says you should have almost half your money invested in the United States, around 10% in Japan, 8% in the UK, 4% in France, and so on. However, there's room for a little adjustment as I will discuss below.

    Country % Global Capitalization Domestic Bias
    Japan 11.291.86
    UK 8.131.67
    Hong Kong1.822.66
    South Africa0.694.57
    (Data from What Determines the Domestic Bias and Foreign Bias? Evidence From Mutual Fund Equity Allocations Worldwide, Chan, Covrig, and Ng, Journal of Finance, June 2005).

Why is market capitalization a reasonable way to measure an economy? China's market capitalization is a tiny 1.37%, whereas China is one of the worlds largest economies. Shouldn't you put more money into China than this table suggests? No. The reason why not is that the above table lists the investments that are available to you--the ones available through the stock market. If you are able to invest directly in China--say by flying over and setting up a new factory--then you could argue that the GDP number is a better measure. So long as you are investing in stocks through a stock market, use the 1.37% for China.

Now let's turn to the question of whether following a strict market-size approach is correct. If all other things are equal, it would be. But of course all other things are not equal: There are several commonly cited reasons why you should invest more of your money in domestic securities. First, your retirement expenses will be paid in Canadian dollars. Second, trading costs are somewhat lower when you invest at home. Third, you have more information about Canadian companies than you have about foreign firms. However, each of these arguments has a weakness.

While it is true that your retirement expenses will be paid in Canadian dollars, there are two counter-arguments. First, rampant inflation in Canada could wipe you out, so you are taking a substantial risk. Canadian-only inflation could happen if some adverse event afflicted Canada but not other nations--for example, the potential separation of Quebec, or an inept fiscal policy. You benefit from Canadian over-investment only if the Canadian dollar strenghens, but not if it weakens. Second, the same argument should apply to American, Japanese, and UK investors, but investors in those countries are more willing than Canadians to put their money overseas.

It is also true that trading costs are lower when you buy Canadian investments: It typically costs $29 CAD to buy a Canadian stock or exchange traded fund, whereas it costs $29 USD to buy an American one. On top of that you have to pay for currency conversions. There are also dividend tax advantages, outside an RRSP, for investing domestically. Nevertheless, you can invest abroad relatively cheaply these days: Pool up your money in an open-ended fund and then throw it into a foreign ETF in one lump sum. The $29 USD won't matter. Also, inside your RRSP the tax consequences are irrelevant. In fact, if you have non-registered investment a strong argument can be made that you should have NO Canadian content in your RRSP: You should hold it all outside the RRSP, in the non-registered account, where it's tax advantages accrue.

You do have more information about Canadian firms, but investing in what you know is a bad thing. You have that information because you are more connected to Canadian firms: Your job, the value of your home, and so on, depend on the Canadian economy. You are already fairly "concentrated" in Canada. Before you bought your first mutual fund your career, pension, and real estate made you over-concentrated in Canada! So while it's true that you know more about Canada than you know about Japan, you've already got a lot invested in Canada. There isn't much of an argument for adding even more.

Despite my objections, there's some room for compromise. You might want to pump up your Canadian holdings a little bit on the grounds that you will have more expenses here, and that it is a little cheaper. I wouldn't bump it up a lot, but perhaps you could raise your Canadian holdings by as much as 100%, pushing them up to 5-6% of your total holdings. I really wouldn't suggest you go any higher than that with your equities.

Your bonds, however, are another matter. It doesn't matter quite as much whether your bond is denominated in Canadian or US dollars. Yes, you are subject to currency risk if you over-weight a particular currency. You bonds will get trashed if the Canadian dollar inflates. On the other hand, this is somewhat mitigated by the argument that your expenses are also in Canadian. With bonds it's less important to track individual nations overall market capitalizations--you could consider equal-weighting th worlds major currencies for example, which would result in massively overweighting Canadian bonds. You could even just split your bonds 50-50 with American bonds.

In the end, foreign asset allocations is a hotly debated topic in finance. I can't give you a definitive answer to this question because there is little agreement. What I feel I can say, with some certainty, is that Canadians ought to invest more of their RRSP than they do in foreign equity mutual funds and exchange traded funds. We ought to have a little bit of bias towards our own market, but not nearly so much bias as we evidently have. Most people would be better off if much more of their money went to the United States and overseas. At least we should invest more in the US and EAFE mutual funds. It is my personal belief that we should invest more than we do in emerging markets as well--though that is harder to justify.

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