Ask the Spud: Does Home Bias Ever Make Sense?

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 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.

36 Responses to Ask the Spud: Does Home Bias Ever Make Sense?

  1. Andrew May 22, 2012 at 11:30 am #

    Great summary article.
    It make some sense then to hold Canadian equity in unregistered accounts because of tax treatment.

    Further to the idea of looking at overall asset allocation: The withholding tax issue in RSP for foreign equity XSP, XIN, CWO etc… is another reason to look at the entire tax picture across accounts and to consider the balance between bond ETFs in registered accounts and the equity ETFs in unreg accounts. Also cap gains are only taxed (for now) at half the rate of ordinary income in unreg accounts.

    Question: I have never sold any foreign ETFs in a registered account. Does the withholding tax in any way apply to cap gains for foreign equity ETFs in a registered account like RRSP, TFSA or RESP? I know cap losses are “lost” in unreg acct’s because they cannot be used to offset gains, but what about the cap gains?

  2. Canadian Couch Potato May 22, 2012 at 11:40 am #

    @Andrew: Glad you found this useful. To answer your questions, there are no tax consequences when selling a US or international ETF in a registered account, whether at a loss or at a profit.

  3. Dave May 22, 2012 at 12:04 pm #

    Dan,

    Great post on keeping your eye on the big picture as well as watching the nickels and dimes on the wo tax as they all add up over an investing lifetime

    cheers

  4. Potato Salad May 22, 2012 at 12:25 pm #

    Dan, are there any tax implications for TD e-series international and US indexes held in registered accounts? (either currency hedged or not). Thanks

  5. Doug Cronk May 22, 2012 at 5:05 pm #

    Interesting to note that the average Canadian Pension has (slowly) reduced Canadian Equity allocations:
    1990 (23.7%) 1995 (29.3%) 2000 (27.9%) 2005 (24.0%) 2010 (16.0%)
    … to both participate in a broader universe and especially to reduce volatility.

    Recall that until 1994 only 10% foreign content was allowed. Then 20%. 30% in 2001. 100% in 2005.

  6. Peter May 22, 2012 at 11:18 pm #

    To Potato Salad:
    Why would there be any tax implications for TD e-series in a registered account? Whether it is TFSA or RRSP, I think there is no tax consequences for capital gains or quarterly/annual distributions.
    If you hold US or Int’l e-series in non-registered account, then all distributions are counted as taxable income. Capital gains tax is 50% of gain?? This is what I understand.
    Hope Dan can correct me and clarify this.

    Peter

  7. Canadian Couch Potato May 23, 2012 at 9:59 am #

    @Potato Salad and Peter: A couple of clarifications here. Any foreign investment (US or international) in a TFSA is subject to withholding taxes. Our tax treaty with the US only covers retirement accounts, and TFSAs do not qualify:
    http://www.canadiancapitalist.com/withholding-tax-tfsa-investments/

    Canadian-domiciled ETFs and mutual funds that hold foreign stocks may also be subject to withholding taxes, because the owner of the stocks is technically the fund and not you.

    Peter, your other assumptions are correct: foreign dividends are fully taxed as income, and capital gains are taxed at half that rate.

  8. Dan May 23, 2012 at 10:44 am #

    About “not exempt from the withholding taxes of countries other than the US”, I could have sworn that Canada had treaties with most of the MSCI EAFE countries (for example) to cover RRSP taxes.

    Our tax treaty with Switzerland (http://www.collectionscanada.gc.ca/webarchives/20071126042617/http://www.fin.gc.ca/news97/data/97-045_1e.html) says: ” interest arising in a Contracting State and paid to a resident of the other Contracting State which was constituted and is operated exclusively to administer or provide benefits under one or more pension, retirement or other employee benefits plans shall not be taxable in the first-mentioned State provided…”

    Some cursory Google searches aren’t giving me any relevant info, besides raising the complication that withholding taxes for a US ETF of international stocks may be taxed based on treaties between the US and those countries.

    This seems terribly complex, and I have no idea what the actual situation is. By the way, how do you even tell that withholding taxes are causing drag inside an ETF?

  9. Canadian Couch Potato May 23, 2012 at 11:01 am #

    @Dan: Thanks for pointing this out. To be honest, I am not certain how many countries waive the withholding tax for Canadian retirement accounts, but it is probably a safe assumption that at least a few of the EAFE and emerging countries do not, so it is reasonable to expect some drag on the returns of these funds. You would see this in the tracking error, since the index benchmarks do not include withholding taxes. As long as these tracking errors are only slightly larger than the funds MER, I would not worry too much about it. The benefits of international diversification outweigh the relatively small cost of withholding taxes.

  10. anon May 23, 2012 at 2:36 pm #

    Dumb question, if I may: are TD US/Dow/Nasdaq e-series held in an RRSP still subject to US withholding taxes? Or is this only applicable to directly held stocks?

  11. Canadian Couch Potato May 23, 2012 at 4:53 pm #

    @Anon: Not a dumb question at all. If you hold foreign stocks via a mutual fund in an RRSP, you are subject to the withholding tax:
    http://www.finiki.org/wiki/Tax-Efficient_Investing
    http://v1.theglobeandmail.com/partners/free/globeinvestor/investment/may08/online/tax.html (see point 6)

  12. CanadianInvestor May 24, 2012 at 4:34 am #

    Another reason to hold more Canadian equity: rising correlations reduce the diversification benefit of foreign holdings.

  13. anon May 24, 2012 at 6:11 am #

    Hmm…good to know. One more reason for me to eventually “graduate” away from e-series and move into a US-based ETF…

  14. Canadian Couch Potato May 24, 2012 at 9:06 am #

    @CanadianInvestor: I have heard that argument many times, but I don’t think it holds up, especially for Canadians. Our market is so concentrated on commodities and banks that it does not behave much like the global market as a whole. It’s simply not possible to build a properly diversified equity portfolio with Canadian stocks.

    It’s true that correlations get close during global crises, but that has always been true, and even then, not everything falls at the same rate. The theoretical case for global diversification is as strong as it has ever been, I think.

    Swedroe has looked these issues:
    http://www.cbsnews.com/8301-505123_162-37842238/why-concerns-about-diversification-are-overblown/
    http://www.cbsnews.com/8301-505123_162-37840389/international-diversification-rising-correlations/

  15. Francis May 24, 2012 at 11:30 am #

    So if, If I own TD e-serie for US and International, I will pay the withholding tax even in the RRSP. So is there a way to get it back, if yes, does TD fill the form for us.

  16. Canadian Couch Potato May 24, 2012 at 11:41 am #

    @Francis: Unfortunately, withholding taxes are not recoverable in an RRSP.

    The drag on returns caused by withholding tax is not trivial (15% on a 2% dividend amounts to 30 basis points), but I don’t think one should give up the benefits of global diversification just to avoid it. In a small account, 30 basis points is not a lot of money, and in a larger account, you can switch to US-listed ETFs to avoid most it.

  17. Jas May 24, 2012 at 5:46 pm #

    The following article from Dimensional fund advisors is a nice summary of the different witholding tax levels with canadian mutual funds like TD eseries and DFA funds vs. US listed ETF vs Canadian wrap ETFs , depending on the type of investing account (taxable vs RRSP)`:
    http://dl.dropbox.com/u/3321363/Foreign_Withholding_Taxes.pdf

  18. Canadian Couch Potato May 24, 2012 at 6:25 pm #

    @Jas: Thanks for the link to an excellent resource!

  19. Adam May 25, 2012 at 11:13 am #

    Dan, with regard to minimizing withholding tax impact on US equity funds/ETFs held in an RRSP I wasn’t aware that holding a US listed fund would eliminate withholding taxes. I currently hold TD e-Series US index in my RRSP and as it stands today the sum invested would not warrant a change. However, as my portfolio grows it may be worth changing my strategy. In order to gain an exception from withholding tax does it matter if the US ETF is held in US or Canadian dollar RRSP account? In order to justify the change I assume one would have to balance the FOREX charge at the time of purchase against the long term dividend yield and withholding tax?

  20. Canadian Couch Potato May 25, 2012 at 11:24 am #

    @Adam: The withholding tax should be waived in any RRSP, regardless of whether the security is held on the Canadian or US dollar side of the account. But you’re right: if you have to endure currency conversion charges when you buy US-listed ETFs, you can easily wipe out the benefits of the lower MERs and the absence of withholding tax. It’s always a tradeoff, which is why I would not be too quick to migrate from index mutual funds to US-listed ETFs. Your portfolio has to be quite large before the savings are realized.

  21. jerry May 26, 2012 at 3:44 am #

    It’s not clear to me what amount of ex-Canada exposure you recommend.

    For instance, your ‘yield hungry’ model is only about 20% outside Canada (5% CHB/10%CYH/half the contents of the 10% XPF), which seems appropriate to me but I have the impression that you and your readers are recommending a larger proportion.

    I am indeed ‘yield-hungry’ but prefer relatively predictable Canadian-dollar nominated yields as I spend most of my time in Canada, my expenses are nominated there, and my opportunities are there. Why would I induce more than a modicum of currency risk to add a (possible) few points to my yield?

  22. Canadian Couch Potato May 26, 2012 at 8:31 am #

    @Jerry: In my view, about 20% to 40% of your overall equity investments should be in Canada. However, the Yield Hungry Couch Potato is designed for taxable accounts, so it makes sense to overweight Canada there. Someone using this portfolio might consider a little more international exposure in their RRSP to compensate.

    Note that CHB and XPF are hedged to the Canadian dollar, so the only currency exposure in the portfolio is in CYH. A small amount of currency risk should actually lower your volatility.

  23. Rick May 26, 2012 at 8:58 pm #

    Adam:

    Just to add to Dan’s comments which I agree with. If you do switch to US ETFs at some point setting up a synthetic DRIP can minimize the forex expenses. I own VEA, VTI, VWO, but concentrate them each in one account (eg. personal RRSP, Spousal RRSP, and Personal RRSP) in order to ensure an efficient DRIP and minimize forex on the loose change not used to purchase new shares in each account.

  24. Canadian Couch Potato May 26, 2012 at 10:03 pm #

    @Rick: Can I ask which brokerage you use? My understanding is that few brokerages allow DRIPs with US-listed ETFs.

  25. Rick May 27, 2012 at 12:50 pm #

    Dan: I use TD Waterhouse. Based on your post I checked with them and was told that my Vanguard dividends are hit with FX charges as they are converted to Canadian prior to the synthetic DRIP being engaged. Then the amount available to buy whole shares is converted to US (fx charges again) and only the trade commission is saved.

    There is talk about having a US side to RRSPs in the future which would avoid this issue, but at this time it is not available and their autowash feature does not apply to dividends.

    Sorry for any confusion my mistake caused.

    I wonder if RBC who has a US side to the RRSP accounts would avoid this problem, but then I would not be able to buy TD efunds when I am investing small amounts.

    I will add this to one of my several frustrations with Web Broker all of which surround its treatment of US dollars.

    The other main one is when I try to buy US listed ETFs with US dollars that I washed using a Norbert Gambit I can only use the full amount of money converted for the purchase if I call them and have them execute the trade by phone. They only charge me the on-line trade commission, but I end up either having to put in a bid at the ask or set a limit price and then call them back numerous times to modify if the market moves away from me. It is very frustrating to say the least.

  26. mark January 25, 2013 at 2:01 pm #

    Hi,
    How does one feel about the fixed income portion, to divide it as per Garth Turner recommends?
    For instance splitting your fix income portion to include preffered shares CPD(canadian pereffered index)

    So the simple portfolio would look like this?

    XIU- 30%
    XWD-30%

    XBB-20%
    CPD-20%
    Thanks
    Mark.

  27. RJ January 26, 2013 at 11:09 am #

    In registered accounts the tax advantage of preferred shares is meaningless so I see no advantage to them.

    Preferred shares are a hybrid investment that contain numerous risks such as interest rate risk, call risk, credit risk, equity risk too name a few. For me my fixed income holdings should act as a ballast to my equity holdings and therefore be low risk and low expected return. According to the iShares website CPD lost 29% in 2009 at the bottom. That is equity like risk at the worst time when your equities are crashing as well.

    If I want to take more risk in my overall portfolio for a potentially higher return I would modestly increase my allocation to stocks rather than move into preferred shares or debentures.

    You may find this article by Larry Swedroe interesting http://www.cbsnews.com/8301-505123_162-57413922/why-you-should-avoid-preferred-stocks/.

    My last beef with preferred shares are their complexity such as their call structure, whether they are floating rate, while these are less of an issue in an index ETF I still believe that complex investments are generally to the benefit to the issuer. Personally I would only consider holding them in a non-registered account and I would never be comfortable replacing half my fixed income allocation to them.

    Bottom line I am big believer in the Total return philosophy. I also believe that Preferred shares are sell at a higher valuations because of their tax advantages and even higher today because of people searching for yield and fleeing stocks so I would avoid them completely in a non-taxable account. Instead take your risks on the equity side.

    I believe if you do opt for them you should consider something like 50% of your preferred holdings as part of your equity allocation to more accurately reflect the portfolio risk you are taking.

  28. Max March 13, 2013 at 10:38 am #

    I know this is an old thread, but I was asking myself a question on this topic. Should I try to keep my exposure to foreign currency / markets constant as I ajust the ratio of bonds vs equities in my RRSP account?

    I’m 29 and currently building a porfolio with e-series mutual funds. Instead of a 60/40 equity vs bonds ratio, I want to start with a 70/30 ratio and gradually increase the proportion of bonds as the years go by. What I realised is that if I keep the 60/40 ratio you suggest in the Global Couch Potato portfolio, I would have 40% of my assets in foreign markets. But, if I go for a 70/30 ratio but keep the equities divided in 3 equal parts of CAN / US / Intl, I end up with around 47% of my assets outside of Canada.

    In that situation, would it be preferable to increase my ratio of canadian equities to compensate for lesser proportion of canadian bonds that I have? Should I raise my proportion of candian equities to 30% in order to have 60% of my assets in Canada and then decrease this proportion as I increase the proportion of bonds in my porfolio?

  29. Canadian Couch Potato March 13, 2013 at 10:59 am #

    @Max: This is a good question, and one that investors should consider if their portfolios are very highly skewed to either equities of bonds. For example, an investor who is 80% fixed income does not need to consider currency hedging in his foreign equity holdings, because these represent such a small part of the overall portfolio. Conversely, someone who is 100% equities may well want to hedge some of the currency risk.

    In your case, the difference between 40% and 47% exposure is pretty small. Your suggestion sounds fine (i.e 30% Canadian, 20% US, 20% international), but I wouldn’t put too fine a point on this.

  30. Doug Cronk March 13, 2013 at 5:32 pm #

    Apologies if this is a repeat …
    For what it’s worth, this Vanguard.com paper (Home bias, June 2012) has some interesting thoughts on ‘foreign content’. I like it because it’s not U.S.-centric. See the (equity) only efficient frontier on page 3 … 70% world, 30% Canada … and conclusions bottom page 2.
    https://personal.vanguard.com/us/insights/article/home-bias-08152012

  31. Canadian Couch Potato March 13, 2013 at 5:42 pm #

    @Doug: Actually I had not seen this paper, so thanks for the link. You may have inspired a future post!

  32. Jon January 8, 2014 at 12:45 am #

    If I wanted my portfolio to have 30% Canadian exposure, would you suggest I count stocks and REITs together (to say 20% ZCN and 10% ZRE)?

  33. Canadian Couch Potato January 8, 2014 at 8:11 am #

    @Jon: Yes, that sounds right. Real estate is often considered a separate asset class, but technically Canadian REITs are just a subset of Canadian equities.

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