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How to reap the rewards of foreign investments in your RRSP

Most investors don't take advantage of foreign investment opportunities and are too heavily weighted in Canadian investments. Although the federal government allows 30 percent of an RRSP to be invested in foreign companies based on book value, most RRSP holdings don't even come close to that amount.

"That's probably not a good thing," says Dennis Tew, senior vice-president and chief financial officer of Franklin Templeton Investments in Toronto. "They're really missing out on a lot of opportunities out there. Many major industries operate outside of Canada."

Canada accounts for less than 3 percent of the world's capital markets, so investors who hold mostly Canadian stocks and bonds are putting a lot of their investment eggs in one economic basket and exposing themselves to the vagaries of the Toronto Stock Exchange (TSX) at the expense of 97 percent of the world's markets.

Part of the problem is Canadians don't understand the foreign content rules. A 2002 survey by RBC Financial Group found the average RRSP portfolio had only 9.9 percent foreign content, well below the 30-percent cap (investors must pay a one-percent tax per month for any amount that exceeds 30 percent). Only 12 percent of Canadians maximize their foreign content holdings, and more than one-third say they don't have any foreign content at all.

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Those who don't invest outside of Canada are missing out. One only needs to look at the Morgan Stanley world performance indexes (www.msci.com) to appreciate the opportunity foreign markets present. At the end of April, the TSX was down about 0.2 percent. However, Austria was up 24 percent, Greece was up 14.6 percent and Japan was up 13.7 percent.

However, there are some risks to investing offshore, says Adrian Mastracci, financial adviser at KCM Wealth Management Inc., in Vancouver. You expose yourself to foreign currencies, which can be volatile. "For those who don't have the stomach for it, it may not be a good idea to be fully maximized in terms of foreign content," he says.

But if you want to expand beyond Canada's border and not be held back by the 30-percent rule, here are some simple-and perfectly legal-strategies:

Double-dipping
You can skirt the 30-percent cap by engaging in what is known as double-dipping, effectively hiking your foreign content to 51 percent without feeling the wrath of the tax police. Double-dipping hinges on the fact that mutual funds can also avail themselves of the 30-percent foreign-content rule.

First, invest 30 percent of your portfolio in foreign equity. Then, invest the remaining 70 percent of your portfolio in RRSP-eligible mutual funds that maximize their 30 percent foreign content exposure. This hikes your total foreign exposure by an additional 21 percent (30 percent of 70).

Labour funds
Another way to hike the limit is by investing in Labour Sponsored Investment Funds (LSIFs). The federal government allows you to increase your foreign content holdings by $3 for every $1 invested in an LSIF, up to a maximum of 50 percent of your RRSP. However, be aware that LSIFs are risky ventures that invest in early development companies, so they may be too dicey for investors with low risk tolerance.

Clone and index funds
You can sidestep the foreign content restrictions all together by investing in a growing number of specialty products created specifically to deal with the limitations.

First, there are clone funds, 100-percent RRSP-eligible mutual funds that maximize their 30-percent allotment in foreign stocks and then use derivatives to mimic the performance of an actively managed fund within the same fund family, such as a U.S. equity fund or international fund. For example, the Templeton International Stock RSP Fund mimics the popular Templeton International Stock Fund.

By using derivatives, clone funds qualify as Canadian content, but mirror the returns of the foreign mutual fund they copy. You should only consider clone funds once you've hit your foreign-content ceiling of 30 percent. That's because the management fees are usually 0.4 to 0.6 percent higher than the Management Expense Ratio of the underlying fund, which means their overall performance will fall short of the funds they mimic.

If you want to maximize foreign content and are looking for lower fees, then consider a 100-percent RRSP-eligible index fund, such as the iIntR fund from Barclays Global Capital. It tracks the popular international MSCI EAFE Index, but is fully RRSP eligible.

Foreign indexes have traditionally outperformed the TSE. Like clone funds, index funds use derivatives and short-term, fixed-income instruments to mimic the index, and management fees are normally less than 1 percent.

One caveat: there are some risks to the hedge techniques used by clone funds. Future contracts are short-term, so there's no guarantee they will be available down the road. As well, futures and derivatives are purchased through third parties and therefore are exposed to insolvency issues should the third party go bankrupt.

If you prefer sticking closer to home, you can always look at leveraging foreign exposure through the Canadian content of your RRSP. For example, many Canadian companies, such as Sherritt International, Bombardier and Alcan Aluminum, earn much of their revenue outside our borders, but still count as Canadian content. As well, Canadian bonds issued in foreign currency also qualify as Canadian content in RRSPs, but provide foreign exposure.

Jim Middlemiss is a freelance writer and lawyer based in Toronto. He's a frequent contributor to National Post, Investment Executive and Wall Street & Technology.

-- Posted: May 7, 2004
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