RSP index
funds have varying currency policies
Investors
that are fortunate enough to have a substantial portfolio both inside and
outside of tax-deferred registered plans probably don’t feel restricted by the
foreign content limits in such plans. These investors can gain greater exposure
to foreign markets by holding more foreign investments outside of RRSP/RRIF
plans. However, for those with most of their savings inside of these plans,
there are few choices available to boost foreign content. Most will look to
fully RRSP eligible foreign funds like index funds and RSP clone funds. When
choosing RSP eligible index funds, be mindful of each fund’s currency policies
and exposure.
It was
nearly ten years ago when the fund industry’s first innovation was born to
skirt foreign content restrictions. At that time, allowable foreign content in
tax-deferred savings plans was just ten per cent. With the help of Newcastle
Capital Management, NN Financial launched the very first investment fund
offering exposure to foreign stocks, while qualifying as 100 per cent Canadian
content. The fund was the NN Can-Am fund, and it was a segregated fund tracking
the S&P 500, a benchmark for large US stocks. (This fund was renamed to
Transamerica IMS Can-Am fund after NN Financial’s seg funds were sold to
Transamerica Life.) So how did they do it? Using something known as index
futures contracts - a type of derivative instrument.
Let’s start
with some definitions. A derivative instrument is simply something whose value
is “derived” by the value of some other underlying investment, commodity, or
security. In other words, its value depends on, or is linked to, the value of
something else. A futures contract is a standardized legal contract that trades
on an organized exchange, like the Winnipeg Commodity Exchange (http://www.wce.mb.ca/), the Chicago Board of
Trade (http://www.cbot.com/), and the London
International Financial Futures and Options Exchange (http://www.liffe.com/). While some may have
heard about futures based on pork bellies, orange juice, corn, and wheat, we’re
going to talk about equity index futures. Without getting into cumbersome
details, a futures contract on the stocks that make up the S&P 500 index
has the following highlights:
-
the
buyer enters into a contract to buy a specified amount of S&P 500 stocks
from the contract seller at a set price and date;
-
the
cost to buy the contract is about one-tenth of the amount of S&P 500 stocks
the buyer has committed to purchase (i.e. the buyer can put up a small amount
to buy the contract, keep the rest in cash to cover the contract obligation,
and yet have a stake in a much larger amount of stocks); and
-
the
contract is settled in cash with the seller upon the contract’s expiry.
Hence, a
mutual fund wanting to use futures to gain exposure to the US market would buy
S&P 500 index futures would invest about ten per cent in index futures
(i.e. the margin requirement) and hold the remaining ninety per cent in cash.
Since the futures are leveraged (i.e. the stock exposure provided by the
futures is equal to the sum of the margin and the cash), the price fluctuations
of the futures contract will be similar to funds actually holding a portfolio
full of S&P 500 stocks. Funds using index futures remain Canadian content
because only ten per cent or so is actually sitting in futures contracts, while
about ninety per cent is in Canadian treasury bills (cash).
Using RSP
eligible index funds getting exposure to the S&P 500 as an example,
investors aren’t always getting what they think they are. Buying a regular fund
investing in US stocks exposes investors to both the foreign stocks and the US
dollar. While the stocks in the fund are held in US dollars, the mutual fund
itself is converted back to Canadian dollars – hence giving investors full currency
exposure. With RSP eligible index funds, it’s not so straightforward.
Some funds
choose to fully hedge the US dollar, which means that they will effectively
eliminate exposure to the US dollar. Yet others assume investors placing their
money in foreign stocks want the currency exposure to go along with it, and
structure their funds to provide this exposure. So RSP eligible US index funds
track one of two different indexes: the
S&P 500 US$ (fully hedged) or the S&P 500 C$ (unhedged). Which index
does your fund track?
There exist
nearly sixty investment funds tracking a large-cap US stock index – mainly the
S&P 500 index. However, only seventeen actually have expense ratios under
1%, while just a handful can be found with expenses of 0.50% or lower. Of the
lower cost and more popular US index funds, here is a breakdown of which funds
track which index.
Funds
tracking the S&P 500 US$ (no foreign currency exposure): TD US RSP Index (both e and A classes),
Altamira Precision US RSP Index, and Royal US RSP Index.
Funds
tracking the S&P 500 C$ (full foreign currency exposure): CIBC US Equity Index and the iUnits S&P
500 Index RSP fund. The latter is an exchange-traded-fund and is traded on the
Toronto Stock Exchange (symbol: XSP)
Whether
investors should have full currency exposure is somewhat of a personal choice.
If you think the Canadian dollar is going to strengthen against the US dollar,
those funds with no foreign currency exposure (i.e. fully hedged) will
outperform their unhedged counterparts. Funds offering full foreign currency
exposure, however, will perform better if the Canadian dollar continues to
weaken.
The one
firm recommendation I will make is to never hold these types of funds in a
taxable account. The large holdings in treasury bills and the tax treatment of
futures results in significant annual distributions, so keep these funds inside
of your RRSP, RRIF, or other tax-deferred savings plan.
Dan Hallett, B.Comm.,
CFP is Senior Investment Analyst with Sterling Mutuals Inc. He can be reached
at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.