Home of the brave

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  By Guest Blogger Sinan Terzioglu

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Nobel Prize winner and economist Harry Markowitz famously stated diversification is the only free lunch in investing. It can help manage risks and improve an investment portfolio’s long term returns. That includes going beyond the loonie.

Despite the advice, many Canadian portfolios are often denominated entirely in Canadian dollars and as a result these folks are missing out on the benefits of currency diversification.

For Canadian investors intending to retire in Canada, as well as for those already retired, the most optimal currency allocation within a portfolio is approximately 75% of assets in Canadian dollars and the remaining 25% in US dollars. Here’s why:

1. Risk Mitigation – In the world of finance, the term “risk-off’ describes a market environment where investors become more risk-averse, often due to economic uncertainties and/or geopolitical tensions. In this environment, investors shift funds from riskier assets like stocks and high-yield bonds to safe-haven assets such as US Government Treasury Bonds. This demand for US Treasuries leads to the US dollar appreciating. For Canadian portfolios holding US dollar-denominated assets, the strengthening US dollar helps mitigate portfolio volatility during turbulent market conditions.
2. Home Country Currency Bias – A recent Vanguard report indicates that Canadian securities now make up about 50% of Canadian portfolios, a decrease from 67% in 2012. While making progress towards having about 30% of their equity allocation in Canadian equities, many Canadian investors still predominately invest in US and global ETFs that are hedged to the Canadian dollar. Consequently, their portfolios miss out on the diversification benefits of having US dollar exposure.
3. Commodity Price Weakness – Canada’s equity market is heavily weighted towards the materials and energy sectors. As a result, when commodity prices fall, the Canadian dollar tends to weaken against the US dollar. Holding US dollar-denominated assets can provide some protection against this depreciation during periods of declining commodity prices.
4. US Withholding Tax – Under the Canada-US tax treaty, RRSPs, RRIFs, LIRAs and LIFs are recognized as retirement accounts, which means that US dividends paid into these accounts from US listed equity ETFs are exempt from the usual 15% withholding tax which applies in non-registered accounts and TFSAs. This exemption is a big advantage, as it allows Canadian investors to receive the full amount of their US dividends, enhancing the overall returns while benefiting from the diversification benefits of having US dollar exposure.
5. Sector Diversification – The US market offers a wide range of sector-specific and thematic ETFs that are not available in Canada. This enables investors to specifically target fast growing sectors like technology and healthcare, which are underrepresented in the Canadian equity market.
6. Cost Effective – Many US-listed ETFs have lower expense ratios compared to their Canadian counterparts, making them a cost-effective option for building a balanced and globally diversified portfolio.
7. Fixed Income Diversification – US and global bond ETFs can provide additional diversification benefits because US and international bonds often have different yield and interest rate dynamics compared to Canadian bonds, potentially improving overall portfolio stability.

Canadian-listed ETFs holding US bonds are generally exempt from US withholding tax on qualified interest income, regardless of whether or not the ETF is held in taxable or non-taxable investment accounts. Given the potential for short-term currency fluctuations, I recommend retired Canadian investors who depend on interest income from their fixed income investments to hold US and global fixed income ETFs that are hedged to the Canadian dollar. Additionally, they should allocate all US dollar-denominated assets to the equity portion of their portfolios.

For US equity allocations, we suggest a mix of Canadian dollar-hedged and US listed ETFs. Since TFSAs are subject to the 15% US withholding tax on US dividends, we recommend holding a mix of Canadian dollar-hedged and unhedged ETFs tracking the US market in TFSAs. ETFs tracking the S&P 500 will mostly do the job but for additional diversification benefits, we recommend adding ETFs that focus on specific market segments such as value and small cap equities as well as high growth sectors.

For international equity allocations, we suggest primarily using US-listed equity ETFs that focus on global equities because Canadian-listed ETFs that invest in international equities via a US-listed ETF may face both US and foreign withholding taxes, leading to double taxation. This approach also makes it simpler for an investor to allocate approximately 25% of their portfolio to US-denominated assets.

Balanced and diversified portfolios with 25% allocated to US dollar-denominated assets, offer Canadian investors enhanced risk management, exposure to faster growing and more dynamic global markets, and protection against currency fluctuations. In an uncertain world, this approach helps add additional protection and ensure long-term financial stability.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.