Note: This article is part of Morningstar's January 2015 RRSP Check-up special report.
Investors around the world have a tendency to concentrate their investments, especially equities, in domestic markets. Home country bias exists due to a number of practical and psychological reasons: some investors prefer to keep their investments close to home because of currency concerns; there can be higher costs and restrictions associated with investing abroad; and favourable tax treatment for domestic equities makes them more attractive to local investors. Another important contributing factor to home country bias is investors' tendency to have positive feelings toward the country and companies that they are familiar with.
However, concentrating your RRSP investments in Canadian equities could bring additional risk to your portfolio. In terms of market capitalization, Canada accounts for about 4% of the world's equity market, and we are highly weighted to the financials, energy and materials sectors. Therefore, when focusing the bulk of our investments in Canada, not only are we ignoring 96% of the opportunities in the rest of the world, we are also neglecting some sectors that are under-represented in this country such as health care, information technology and consumer goods.
This lack of global diversification in an investment portfolio can pose great risks should the home country suffers economic downturns, as exemplified by the recent rapid decline in oil prices and the weakening of the Canadian dollar. This had a major negative impact on the return of Canadian equities; the S&P/TSX Composite Index lost more than 2% over the six-month period ending Dec. 31, 2014, while the MSCI World Index gained 7.7%.
Canadian investors' habitual overweight in domestic assets are partly a legacy of regulations formerly imposed by the Canadian government. Until February 2005, the Foreign Property Rule restricted Canadian investors from investing more than 30% of their tax-deferred retirement assets in foreign securities. Introduced in 1971, the Foreign Property Rule was a way of supporting the development of the Canadian financial markets. The initial limit was set at 10% of the portfolio assets, and it was gradually increased to 20% in 1994 and then to 30% in 2001.
The rule prevented individual investors and registered pension plans from investing more than the prescribed limit of the portfolio in assets outside of Canada. Investors who wanted to gain exposure to foreign securities above the allowable limit had to do so through derivative products that were often more expensive and had higher risk than the ones that invested directly in foreign investments.
The elimination of the Foreign Property Rule on Feb. 23, 2005, was major news for Canadian investors with tax-deferred retirement plans. It meant individual and institutional investors no longer needed to concentrate their retirement investments in domestic securities, and their tax-deferred accounts can now consist solely of non-Canadian assets if they chose to.
The expectation when the Foreign Property Rule was lifted was that investors would significantly increase their investments in foreign securities. However, this shift has not occurred. Almost a decade after the rule was scrapped, most assets in tax-deferred retirement plans are still heavily invested in Canadian securities.
A global pension asset allocation study conducted by Towers Watson shows that an average Canadian institutional pension plan's Canadian equity exposure relative to total equity was 30% in 2013. Although this figure is down substantially from 60% in 2002, it still represents a major overweight in local equity markets. On the individual side, for those who have access to company-sponsored group retirement saving plan and have elected to invest in one of the pre-packaged target-risk or target-date funds -- both of which are popular investment options for Group RRSPs -- the average Canadian equity allocation to total equity stands at roughly 36%.
These data show that although Canadian investors, both retail and institutional, are looking outside of Canada for investment opportunities, there is still a significant overweight to the domestic equity market. Despite the presence of some excellent Canadian investment opportunities, Canadian investors could really benefit from diversifying their portfolios outside of Canada.
Asset allocation for registered accounts should not be done in isolation since an RRSP is but one part of an investor's overall investment plan. The The asset location decision -- the process of determining what assets should be held in which type of accounts -- could have huge impact on overall portfolio performance. The general rule of thumb is to hold assets that have less favourable tax treatment (i.e. fixed income) in a non-taxable/registered account and holding assets with favourable tax treatment (i.e. equities) in taxable accounts. However, foreign stocks don't get the same tax treatment as Canadian stocks. In addition, withholding taxes for foreign equity funds varies depending on the structure of the fund.
Deciding how assets are distributed between registered and non-registered accounts is a complex and highly individualized process for which there is no one-size-fits-all solution. An individual's tax rate, the type of securities that person owns, the different tax treatment for each security type, the structure of investments funds and the size of the portfolio all play a role in determining which asset class and the type of securities or funds to hold in taxable and non-taxable accounts.
An investor's asset allocation strategy should drive all asset location decisions. And an asset location strategy should be tailored to an individual's specific circumstances so that person's asset allocation strategy can be implemented in a tax efficient manner.
