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RRSP Foreign Content Rules Scrapped!
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RRSP Foreign Content Rules Scrapped!

Contributed by: martingale

Investing Suddenly I love our Finance Minister. Effective immediately the foreign content restrictions on RRSP's have been eliminated. This is a huge and wondeful change: You can now own as much United States, European, and overseas content as you like in your RRSP.

So how much should you buy? This article will take a look at how you should structure your investments under the new rules.



CAUTION: The current government is a minority government. Should the government fail to pass the budget this "effective immediately" proposal may never come to pass. I recommend that you hold off doing anything until the status of this act is clarified.

There is still some argument for owning Canadian securities. The Canadian economy represents 2-3% of the global economy, so you should hold 3% Canadian no matter what. Next, commissions on buying Canadian securities remain slightly lower than when you buy foreign securities--it costs about $25 CDN to buy a Canadian stock, and $25 USD to buy American.

A Basic Asset Allocation

Adding that up, a reasonable overall portfolio might now look like this:
  • 35% United States equities
  • 25% European, East-Asian, and Far-East equities
  • 10% Emerging markets
  • 10% Canadian equities
  • 10% REITs (including foreign)
  • 7.5% Oils and energy
  • 3% Precious metals

Such a portfolio would ensure that you are globally diversified roughly in proportion to the size of the economies around the globe. Since the overall allocation of money to markets is reasonably efficient you can't go too wrong this way.

Canada has been significantly overweighted because it is much cheaper to invest here. Oils and energies and precious metals are included as a hedge against inflation and as a hedge against an oil-driven market crash. Since Canada is a resource intensive country, it's sensible to pick up a large part of these hedge investments on the cheaper Canadian markets.

Thinking About Currency

There is one problem with the above portfolio: Currency risk. If you know that you will retire in Canada, then you know that your retirement expenses will be funded in Canadian dollars. What if the Canadian dollar continues to rise like crazy? It could devalue all of your foreign investments, from a Canadian point of view. Of course if you are planning to leave the country when you retire then perhaps you need more foreign currency exposure.

Mitigating currency risk is a strong argument for overweighting your Canadian investments. You need not ruin your global diversification, though, you can do it this way:

  • Hold primarily Canadian dollar denominated bonds.
  • Use Canadian companies to satisfy the energy and precious metal components

The above asset allocation describes the equities portion of your portfolio only. One way to mitigate the currency risk is to hold the entire bond portion of your portfolio in Canadian dollars. There isn't nearly as much benefit in diversifying your bond holdings internationally as there is in diversifying your equities. Therefore, you can safely maintain a global equity allocation by concentrating your bond holdings in Canadian dollars.

How much of your investments should be in bonds depends very much on your life situation. Young working people may have just 15-20% invested in bonds; while retiree's probably ought to have 70-80% in bonds. This has always been sound advice, and it is even sounder if your bonds are Canadian holdings: The closer you get to retirement the more of your holdings will be in Canadian dollars (bonds) and therefore the less you'll have to worry about currency fluctuations.

Canada is also a major player in the worlds energy and metals markets. The 10% that I suggested you invest in these areas could reasonably be invested with Canadian dollars. You could also consider putting a small portion of your REIT holdings into Canadian REIT's, maybe even up to half of the 10%.

If we add that all up you've got 20-25% of your equities in Canadian dollar securities. If you also have all of your bonds in Canadian dollars then your exposure to currency shifts will range from 60% of holdings for young risk-takers, down to just 20% for older more conservative investors. That should provide adequate protection from the whims of the swinging Loonie while still ensuring a proper global allocation.

Thinking About Taxes

Here is an important tax tip to remember: Canadian equities receive very favourable treatment outside an RRSP in the form of the dividend tax credit. Therefore, if you hold investments both inside and outside an RRSP you should seriously consider holding your Canadian investments outside the RRSP.

The consequence of this is that, now with the new rules, for many investors it may make perfect sense to have an RRSP with no Canadian equities if adequate exposure to the Canadian equity market can be held outside the RRSP.



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RRSP Foreign Content Rules Scrapped!
Authored by: FrankW on Monday, February 28 2005 @ 10:28 PM EST
Martingale,

You mention there being little purpose in diversifying bond holdings. I thought that bond
holdings were alot more sensitive to hyper-inflation than equity holdings. That is
should the Canadian dollar hyper-inflate bond holdings denominated in Canadian
dollars would become nearly worthless, while Canadian equities could (roughly)
be expected to grow in value (in CDN) along with the hyper-inflation.

So, if hyper-inflation is a concern, it seems like diversifying bond holdings amoung
a few major currencies would be a good idea.

While I see no hyper-inflation risks in the short term, in the medium to long term it
always seems to exist as at least a small but potentially debilitating risk, especially
in a smaller nation like Canada. So for longer term bond holdings would it not
be prudent to hold some in other currencies? Or am I just making things unnecessarily
complex?

Best regards,

FrankW
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