Many Canadian investors suffer from home country bias by holding all, or a large portion of, their investments in Canadian stocks. This makes little sense for those looking to build a diversified portfolio. Canada makes up just 3 percent of the world’s market capitalization and its markets tilt heavily towards financials (banks & insurance) and resources (oil & gas).
As Exchange-Traded Funds (ETFs) grow in popularity it has never been easier for investors to access foreign markets and diversify their portfolio. International diversification helps reduce the overall risk of your portfolio and provides exposure to market sectors that may not be available in Canada.
Besides, not every market performs well at the same time. Canadian stocks might be slumping while U.S. or international markets are soaring. There’s also currency risk to consider: when the loonie falls in value, foreign stocks may be worth more in Canadian dollars.
ETFs are a cheap and easy way for Canadian investors to get exposure to foreign markets. Here are three ways for investors to get international diversification:
1. Go Simple with a one-fund solution
Investors can get all the international diversification they need with just one ETF. That’s right, since the introduction of All World ex Canada ETFs like iShares XAW, investors can own U.S., international, and emerging market stocks with one product for a low management expense ratio (MER) of 0.22 percent.
The pros of this simple approach are obvious. XAW essentially rebalances itself quarterly by tracking the performance of the MSCI All Country World Index ex Canada. That means fewer transactions for investors, since there’s no need to rebalance their foreign holdings.
XAW is a fund of funds, meaning it is made up of five U.S.-listed iShares ETFs, plus one Canadian-listed iShares ETF. With this simplicity, investors give up a bit of cost efficiency. Even at a modest 0.22 percent expense ratio, XAW is more expensive than holding its underlying funds individually.
There’s also an additional cost drag from foreign withholding taxes when this fund is held inside an RRSP or TFSA. This can add an additional 0.30 percent or more to the overall cost of the fund.
2. Get precise with several market-specific ETFs
Some investors might prefer more direct control over the foreign markets in which they invest, either by tilting more heavily towards emerging markets, specific sectors, small-cap stocks, dividends, or even smart-beta.
There’s seemingly an ETF for everything these days, so investors can fill their boots.
The advantage with this approach is the degree of control. Investors aren’t bound to one ETF that follows a certain methodology or set of rules. They can make their own rules, so to speak, and tailor their international diversification to their specific needs or tastes.
So perhaps instead of the popular iShares Core S&P 500 Index ETF (XUS), a dividend lover might opt for iShares US Dividend Growers Index ETF (CUD) or the new iShares Core MSCI US Quality Dividend Index ETF (XDU).
Internationally, the sky’s the limit. For example, the Canadian market has little exposure to health care, so here you could add something like HXC – iShares Global Healthcare Index ETF. Then there’s the Global Water Index ETF (CWW), the Global Agriculture Index ETF (COW), or even the Gold Bullion ETF (CGL).
A trade-off for the extra control and precision is that you’re also adding an extra layer of cost to your portfolio. More ETFs in your portfolio means more trades to buy and rebalance. You’re also adding complexity, which can lead to poor behaviour like analysis paralysis, or anxiety over which funds to buy and when to rebalance.
3. Save more with U.S.-listed ETFs
I touched on foreign withholding taxes and how they can be a drag on returns in tax-deferred or tax-free accounts. Investors can minimize foreign withholding taxes by holding U.S.-listed ETFs.
To do this, investors need to make transactions in U.S. dollars, which either means dealing with the Canadian – U.S. dollar spread, which can be expensive, or trying to implement Norbert’s Gambit, which can be complicated to master.
Venturing down this path can lead to significant savings, though, particularly for investors with sizeable portfolios.
To start, let’s unbundle iShares XAW and look at each of the underlying holdings:
- IVV – ISHARES CORE S&P 500 ETF – 44.26%
- *XEF – ISHARES MSCI EAFE IMI INDEX – 34.54%
- IEMG – ISHARES CORE MSCI EMERGING MARKETS – 12.14%
- IJH – ISHARES CORE S&P MID-CAP ETF – 4.14%
- IJR – ISHARES CORE S&P SMALL-CAP ETF – 4.10%
- ITOT – ISHARES CORE S&P TOTAL U.S. STOCK – 0.80%
*Ignore for the moment that XEF is actually a Canadian-listed fund. It’s more tax-efficient than its U.S.-listed counterpart IEFA.
If you were to buy each U.S.-listed ETF in XAW in their respective weights the total management fee would be approximately 0.11 percent.
The advantage to this approach is lower overall MER for the portfolio and the avoidance, to some degree, of foreign withholding taxes.
Read more about foreign withholding taxes in this excellent white paper by Justin Bender and Dan Bortolotti.
Finally, there’s the workaround called Norbert’s Gambit to deal with. It’s a cheap way for investors to convert Canadian and U.S. dollars by getting around the expensive currency spreads charged by brokerages. But it’s also complicated and investors will also incur an extra set of commissions.
Depending on the size of the trade, such as for large RRSPs, Norbert’s Gambit it may be worthwhile to save investors hundreds, if not thousands, of dollars each year.
Final thoughts on International Diversification
Exposure to foreign markets can lead to higher overall returns and also lower the risk of your portfolio. It’s important for investors to get international diversification in some form, whether it’s from a simple one-fund solution like I use, or through a more precise dissection of the global markets.
I dislike the term ‘sophisticated investor’ so let’s just say there are significant savings opportunities for those investors with sizeable portfolios who also possess the time and temperament to manage a portfolio of U.S.-listed ETFs.