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Table of Contents
Put your financial adviser on a leash
February 11, 2000
100% Foreign content for your RSP
December 22, 1999
Tax Loss Selling or Dealing With Your Mistakes
November 26, 1999
Life Stages of your RRSPs
November 12, 1999
Just give me boring (but great) rates of return
November 3, 1999
De-mystifying Demutualization - part Two
October 25, 1999
De-mystifying Demutualization - part One
October 19, 1999
Seg funds for the simple minded
September 14, 1999
The interest rate game Part 2
August 12, 1999
The interest rate game Part 1
July 30, 1999
Choosing funds: Five for the long run
July 14, 1999
New Funds: To buy or not to buy
July 2, 1999
Making sense of momentum investing
June 18, 1999
Rating the fund managers
June 4, 1999
Resource recovery hinges on supply and demand
April 30, 1999
Tech funds draw strength from favourable trends
March 24, 1999
Withdrawing from your RRSP
March 9, 1999
The economic implications of the euro - An interview with Ranga Chand
February 12, 1999
Underperforming small-cap funds have strong upside potential
January 29, 1999
How to pick a winning equity fund portfolio
January 15, 1999
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100% Foreign content for your RSP

MILES SANTO
Financial Advisor
Wednesday, December 22, 1999

RSPs are normally restricted under government rules to have no more than 20% of the money invested in foreign investments, thereby forcing the Canadian component to be 80% or more. Although this restriction still exists, a new ruling from Revenue Canada has allowed the creation of a new breed of mutual funds that essentially makes the 20% foreign content rule irrelevant.

Why all the fuss?

Foreign investments have tended to perform better than Canadian investments over the long term. In my experience during my twenty two years of investing, I have found that a good diversified portfolio of foreign mutual funds has outperformed a similarly diversified portfolio of Canadian funds by about 5% per year on average. This has equated to an average rate of return of about 18% per year for OPEN (non-RSP) accounts versus about 13% per year for RSP accounts, over the past twenty years. The higher return on foreign funds adds up to huge gains the longer you are invested. For example, if you started with $100,000, the additional 5% return per year would add $165,329 more to your plan after 20 years.

Why have foreign funds tended to perform better? The main reason is that Canada represents only 3% of the world's stock markets, so 97% of the opportunities exist elsewhere. Often if you have a bigger basket from which to make choices, you can find better choices. On the other hand, having a bigger basket to work from entails more work! Global mutual funds or even US mutual funds require a higher degree of expertise in research and analysis to deal with the larger array of stock choices available to them. Therefore, even though there are more opportunities to outperform, there are also more chances to underperform. Indeed, there are many global and US funds that have actually underperformed the best Canadian equity funds over the past decade. Some of the mutual fund marketing literature on this topic implies that you could lessen the risk in your portfolio using more foreign investments. This may be true but the opposite is also true, i.e. you could increase your risk instead, depending on your specific fund selection. So as always it is important to focus on management first, and the geographic element second.

How do they work?

Not only are these new products foreign, but the terminology used to describe them is also 'foreign' to the average investor. How to make a complex subject simple?

Since the foreign content rules have actually not changed, i.e. there still is a 20% real foreign content limit, how do funds become 100% foreign and still qualify for RSPs?

Let's work with $10,000 and we will call the investment a 'derivative' fund. Derivative just means that one investment derives its value from another investment. This should become clearer as I describe an example. The derivative fund takes the $10,000 and invests 20%, or $2,000, directly into foreign equities under existing rules. The remaining $8,000 is invested in money market investments, mostly Canadian government treasury bills, thereby making the derivative fund fully RSP eligible. Now we have spent all the money, so where is the 100% foreign content? The derivative fund then takes the $8,000 of treasury bills to a bank and says, "Please invest $8,000 of the bank's money into a true foreign fund and hold our $8,000 of treasury bills as collateral". The derivative fund writes a contract with the bank that says if the true foreign fund makes a gain at the end of the day then pay the gain to the derivative fund and if there is a loss, the derivative fund will pay this to the bank. This contract with the bank is referred to as a 'forward contract'. The word 'forward' implies that the return on the true foreign fund will be passed down to the derivative fund at a future date, usually every 30 days, although in practice the share price of the derivative fund is adjusted every day to reflect the present value of the true foreign fund. As you can see the derivative fund derives its return from the gains or losses achieved by the investments made by the bank. Essentially the return will then mimic the underlying return of the true foreign fund, minus some expenses associated with writing the contract with the bank.

The return on the derivative funds should end up about 0.5% less than the actual foreign funds they are attempting to mimic, due to the costs involved.

There are three main ways to write the forward contracts with the financial institution (FI), usually a bank.

1. The FI buys shares in the underlying mutual fund that the derivative fund is attempting to mimic. For example, Ivy RSP Foreign Equity indirectly buys Ivy Foreign Equity through the FI.

2. The FI buys shares in the same stocks as those owned by the underlying fund but does not directly invest in the underlying fund. For example, AGF RSP American Growth Class will mimic the return of AGF American Growth Class, but the FI will not buy shares of AGF American Growth Class, instead it buys the stock holdings directly.

3. The FI buys an index of foreign stocks. This was the common method before this year, but produced lacklustre results and has mostly been abandoned as a method.

Most of the mutual fund companies will have a number of these derivative funds by the end of 1999. Many are already available. Initially most of the funds that have been created are clones of the best foreign funds that each fund company already has.

Some Examples so far: AIM RSP European Growth, AGF RSP American Growth, BPI American Equity RSP, C.I. American RSP, Fidelity RSP International Portfolio, Ivy RSP Foreign Equity, Templeton Growth RSP, Trimark Select Growth RSP, and Universal Select Managers RSP.

This article has been reproduced from "The Miles Santo Newsletter" produced by Miles Santo and Associates Inc.

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