In today's interconnected world, communicating with relatives and friends even halfway across the globe is limited only by the hours both parties are awake. Even just a few years ago, the cost of international texting was prohibitive (irrelevant with services like WhatsApp), Skype was the only internet caller (now many messaging services have call options) and video quality was comparable to taking a series of photos with a flip phone from 500 meters away. Technology has truly given us a new perspective on people's lives around the world.
When it comes to investing, the story is similar. Before, it used to be a lot more challenging to invest in foreign equities as information was harder to come by (the internet has solved that), you'd need foreign currency accounts or you were limited to high-cost mutual funds provided by just a handful of major institutions. ETFs, or exchange-traded funds, have experienced a renaissance, providing a tremendous number of choices both domestic and international to investors with just a few clicks (or taps) online, since they are traded like stocks. There are country-specific ETFs listed on the TSX that enable you to get direct exposure to a specific country's main index (ZCH for China, for example). There are very focused, strategic ETFs, like a US high-dividend covered-call ETF, ZWH. There are also sector-specific, levered and hedged ETFs.
All-in-all, Canada has a whopping 478 exchange-traded funds managing $122.9 billion (as of March 2017).
Nestled within these funds are a number of Canadian ETFs that invest in equities that are not in Canada or the US. There are a couple of ways this is achieved, and each method has differing foreign withholding tax implications (the tax is typically 10-15%, depending on the originating country) for dividends paid:
- Directly owning shares of foreign companies
Foreign withholding taxes apply but are recoverable only in a non-registered account
- Owning US ETFs that own shares of foreign companies
Two levels of foreign withholding taxes apply (one for the US fund, one for foreign companies) with only the US fund taxes being recoverable in a non-registered account
Fund providers like Blackrock (which manages iShares ETFs in Canada) that have ETFs in the US use the second method as it makes their job a lot simpler, and it also allows them to have two layers of management fees. What you need to do as a potential fund investor is determine which of these cases applies, as the second one will have a lower return, all else being equal. If you find an international ETF, simply go to the fund page and check what the holdings are.
Using the iShares MSCI EAFE Index (XIN) as an example (EAFE stands for Europe, Australasia and Far East), you'll notice that the "Holdings" section shows a number of currencies in small proportions and iShares MSCI EAFE Index (EFA) as a 100% weighting. EFA happens to be iShares' US EAFE Index ETF, so you can conclude that owning XIN would have you incur two levels of foreign withholding taxes. Interestingly, iShares also offers the iShares MSCI EAFE IMI Fund (XEF) in Canada, with the IMI standing for "Investable Market Index." This means the fund is holding not just the largest capitalization companies in the EAFE world, but mid- and small-cap companies as well. The wonderful thing is that the holdings page shows that only about 5% of the fund is held as EFA. The remaining 95% is split individually between countless companies based in Europe, Australasia and the Far East. From this, you can conclude that more of the dividends are making their way into your account.
When you are investing relatively small amounts, the foreign withholding taxes will not make much of a difference, but with an account value of $100,000 in foreign equities, you are potentially missing out on hundreds of dollars a year because of additional unrecoverable foreign withholding taxes. This $100,000 milestone in foreign equities also involves another consideration - you have to declare to Canada Revenue Agency (CRA) if you have held more than $100,000 in foreign property, which includes stocks, bonds and real estate, on your tax return.
You may be asking whether it is worth it to own international ETFs, with the higher taxes, management expense ratios (MERs) and more complex tax reporting. The confusion makes it common for many Canadian investors to invest heavily in their own country. Not only that, but people are generally a lot more ignorant about what foreign companies are like in terms of scale, products and business-specific details, despite using their products and services frequently.
But the fact is, by not investing internationally, you are missing out on successful, important companies like Shell, Toyota, Nestle and BNP Paribas. And then, there is the correlation factor. With Canada being geographically so close to the US and relying on a huge proportion of imports and exports with the US, Canadian markets tend to move closely with US markets. This correlation has a statistical number associated with it, which is the correlation coefficient. If two indices have a correlation coefficient of 1.00, it means that the markets move perfectly in tandem. If one goes up 1%, chances are the other will also go up 1%. Correlation can change over time, its value rising and falling, and it benefits a portfolio to have parts of it moving at different rates (or having correlations other than close to 1.00). There are ways to show this statistically, but basically, it acts as a buffer in times of severe market declines in a particular geographic region. At the same time, if a particular region does very well, you get to catch the upside in some capacity that may not spill over to other markets.
So, embrace the globalized economy and ease of which it is accessed, and put some foreign equities in your portfolio. In future articles, I will discuss weightings and strategies for using foreign ETFs, so stay tuned!