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The currency game
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.

The beginning of RSP eligible index funds

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.

Index futures - how they work

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, the Chicago Board of Trade and the London International Financial Futures and Options Exchange. 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).

    The currency issue - hedged vs. unhedged

    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)

    Portfolio recommendation

    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, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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