Q: The Global Couch Potato has one-third of the equity allocation in Canadian stocks, but Canada makes up only about 4% of the world markets. Aren’t you guilty of home country bias? – Jeremy D.
I’m actually pleased that I’ve received this question several times in the last few months. Not long ago, it wasn’t unusual for investors to ask why anyone would invest in any country but Canada. Our domestic market was one of the world’s top performers during the first decade of the new millennium, but that’s changed: Canada has now lagged the MSCI All Country World Index by 3.4% annually over the last three years, and we’ve trailed the US over the last five.
That’s a reminder that the long-term expected returns in any developed country are more or less the same. (Since 1970, the average return on Canadian, US and international stocks are almost identical.) However, since each country’s stock market moves along a different path, a globally diversified portfolio should have lower volatility than any single country, and it should boost returns by providing opportunities for rebalancing.
It makes theoretical sense to build an equity portfolio that assigns weight to every country based on the size of its stock market. That would mean allocating about 46% to the US, about 8% each to the UK and Japan, and just 4% to Canada. Why, then, does the Global Couch Potato allocate equal slices to Canada, the US and international stocks?
I’ll admit there is some home country bias in my model portfolios. This simply acknowledges that investors all over the world feel safer holding domestic stocks, and Canadians are no different. A recent survey found they concentrate 74% of their equities in Canadian stocks, which is in line with investors in other countries. So recommending that investors go from 74% to 4% would make the Couch Potato an awfully tough sell. But there are more rational reasons for Canadians to overweight their own country:
Less currency risk. Holding foreign stocks introduces currency risk into a portfolio. Some currency exposure is a good diversifier as it lowers overall volatility, but investors who plan to retire in Canada should probably not have 96% of their equity investments in foreign currency. You can use currency hedging, of course, but this strategy is expensive and imprecise: over the long-term, currency hedging is a significant drag on returns.
That said, it’s important to consider your overall asset allocation when measuring your currency exposure. Most investors hold all of their fixed income in Canadian dollars, with good reason. So if you have a large bond allocation in your portfolio, you can afford to take more currency risk on the equity side.
Lower costs. Canadian equity ETFs and index funds are generally the cheapest to trade and to own. All Canadian ETF providers charge much more for US and international equity funds. While Canadians can (and should) use US-listed ETFs with very low management fees to get exposure to foreign stocks, the cost of trading in US dollars can be high. If you go this route, you certainly need to make an effort to reduce the cost of currency conversion.
A fund’s internal trading costs are also higher in some international markets (especially emerging countries) where stocks may not be as liquid as they are in Canada and the US. Foreign withholding taxes (which often shave 15% off dividend payouts) also take a bite out of international funds. This helps explain why the tracking error on international equity ETFs are often higher.
More favourable tax treatment. Because of the tax credit on eligible Canadian dividends, there is an excellent case for overweighting Canadian stocks in a taxable account. Foreign equities are not only ineligible for this credit, they are also subject to withholding taxes on dividends, often in the range of 10% to 15% (these may be recoverable).
If you’re investing in an RRSP, you probably know you’re exempt from the withholding tax on US securities. However, if you hold US stocks through a Canadian-domiciled mutual fund or a Canadian-listed ETF, you will still pay the withholding tax, even in an RRSP. It’s also important to know that RRSP investors are not necessarily exempt from the withholding taxes of countries other than the US, so the returns on international stocks will suffer slightly in an RRSP.
Simplicity. Remember that asset allocation is not about precision. It’s important for Canadians to get significant foreign equity exposure because our market is so poorly diversified, but the exact proportions are not that important. The equal allocation in the Global Couch Potato is a simple solution that gives you plenty of diversification and still keeps rebalancing easy.