The Canada Day weekend feels like a good time to address a never-ending investment question: What is the right balance in your portfolio between Canadian and foreign stocks?
This topic usually comes up when Canadian stocks are doing particularly well or poorly relative to those in other markets. Recently, it surfaced because of the federal government’s push for large pension funds to allocate more capital to Canada (domestic stocks generally make up a tiny part of their public equity allocation).
Before exploring the question, we need some facts.
The Canadian stock market is relatively small. It accounts for 3 per cent of world indexes.
In it are many world-class companies, the largest of which are either global leaders or domestic giants operating in the friendly confines of an oligopoly.
The industry sector weightings of the S&P/TSX Composite Index are skewed toward a few industry sectors – financial services, energy and materials. Conversely, some important parts of the economy are underrepresented, namely technology and health care.
In the investment industry where products and services are largely undifferentiated, approaches to the Canada-versus-foreign issue couldn’t be more diverse. They range from individual investors who only own Canadian stocks to large pension funds that hold almost none.
According to the International Monetary Fund, 50 per cent of Canadian investors’ equity allocation is domestic. If we exclude the mega-pension funds, the percentage for individual investors is certainly higher. We’re not alone in our home country bias. It occurs in all countries, although is more pronounced in Australia, Japan and Canada.
Oh Canada
There are a number of contributing factors why Canadian investors stay so close to home.
Many like to own individual stocks. Unfortunately, this is impractical when going beyond North America because of a lack of knowledge and high trading costs. Pooled funds and ETFs are the only way to go.
Dividend investing has taken hold in Canada. I hear it regularly – banks, REITs, utilities and forget the rest. For dividend devotees, going global is a hard pill to swallow because yields are lower and capital growth plays a bigger part of the return.
And there is a psychological reason. When Canada is really humming, and/or our dollar is strong, owning foreign stocks is excruciating. There are always periods when your portfolio is out of sync with markets, but it feels worse when your own country is doing well and you’re not fully benefiting.
Now, let’s look at the question in the context of your portfolio.
Home or away
There are good reasons to go all-in on Canada. You’re investing in your own. You know the companies and their products. And there’s no currency risk or tax disadvantage.
Investing outside of Canada, however, allows you to more effectively diversify your portfolio across industries, including those underrepresented in the Canadian market, and not be tied to a single economy and currency.
This diversification translates into returns that are less volatile. You don’t avoid the ups and downs, but the highs and lows are moderated. I’ve witnessed this with our clients. When Canada is roaring, they can’t keep up with their friends who hold mostly Canadian stocks, but the rest of the time they do better.
Importantly, the smoother path doesn’t require a compromise on returns. For sure, Canada has long stretches of outperformance, but global stocks (U.S. and international) have done better over longer periods (10, 20 or 50 years).
What to do
In a recent report, Vanguard Canada recommended an equity mix of 30-per-cent Canadian and 70-per-cent foreign. I concur. In our portfolios, Canada makes up 33 per cent to 40 per cent of our stock weighting, depending on the mandate (income-oriented accounts have a higher percentage).
We’ve settled on this level for three reasons. First, we’re happy to stay in Canada for our income needs. Canada has plenty of good dividend stocks that aren’t subject to foreign withholding tax. Second, there are excellent small-cap companies and we know them well. And third, there are some high-quality growth companies that we want to own.
We can take advantage of all three categories without worrying about diversification because foreign stocks round out the portfolios. The result is a collection of companies that derive 20 per cent of their sales from Canada, 40 per cent from the United States and 30 per cent from international.
In summary, we should celebrate what we have in Canada and invest in it, but not to the exclusion of the many opportunities beyond our borders.
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