For the first time, Canadian investors are experiencing both the heady freedom and increased risk that comes from having absolutely no restrictions on foreign content in their RRSP portfolios.

In its February budget, the federal government surprised the investment community by announcing an amendment to the Income Tax Act that brought an end to the 30% foreign-content limit within registered plans. With that restriction officially lifted when the budget received royal assent in June, investment-management companies have been busy unwinding derivatives that allowed them to circumvent the rules, and merging RRSP-clone funds into their underlying foreign funds. It’s now up to investors, with the help of their advisors, to decide how much of their portfolios they wish to allocate to foreign securities.

Prior to the rule change, there were several hundred RRSP-clone funds, typically charging between 20 basis points and half a percentage point to duplicate the returns on related funds that held foreign securities. Many fund companies didn’t wait for the official passing of the budget before dropping the extra fees on clone funds to match the underlying funds, so there was no incentive for investors to switch out before the new rule was a sure thing.

In late June, once the budget proposal was formally passed, the Canadian Securities Administrators gave mutual fund companies “exemptive relief” from the usual regulatory requirements to provide investors with 60 days’ notice of a fund windup. Fund companies were also exempted from the need to hold a unitholder vote, and were required only to issue a press release and some follow-up communication to investors and dealers. Upon termination of an RRSP-clone fund, unitholders automatically become investors in the underlying fund that the clone mirrors.

Dwayne Dreger, vice-president of corporate affairs for Toronto-based AIM Funds Management Inc. , says within six weeks of the budget receiving royal assent, the AIM Trimark family’s clone funds were gone, but until then, “it was hurry up and wait” for the legislation to pass.

At Mackenzie Financial Corp. , clone funds are also dead and investors are reaping an
immediate pickup because of the lower management fees on the underlying funds into which they’ve transferred, says David Feather, president of Mackenzie Investment Services Inc. in Toronto.

“The death of the clone funds has allowed us to clean up our product shelf, and we now have fewer and larger funds to administer,” Feather says. “It’s an opportune time for clients to review their portfolios. Strong domestic markets in recent years may have taken Canadian allocations higher than desired targets in many cases. It may be healthy to rebalance.”

Surveys have found that, on average, most investors tend to hold the bulk of their assets in domestic securities, and the 30% foreign-content allowance was not being fully utilized. It’s a similar story with pension funds, which are investing about 23% of their assets in foreign equities on average, according to Benefits Canada, although this is a significant increase from 7% in 1990.

“Investors have been constrained in the past and they now have unlimited choice,” says John Boeckh, senior vice president of marketing at Toronto-based Guardian Group of Funds. “It’s a radical change, and it may take a few years for people to alter their behaviour. The foreign-content allowance was underutilized as it was, and Canadians are a cautious group. It’s like inviting people with a small appetite to an all-you-can-eat buffet.”

Foreign markets can provide valuable diversification as well as opportunities not available domestically. However, currency, disclosure and regulatory risks will increase with foreign participation, and must be considered part of portfolio management, along with asset allocation and security selection.

“When you’re increasing foreign content, new currency risks and political considerations
come into play,” says Ralf Hensel, senior counsel at the Investment Funds Institute of Canada in Toronto. “There’s also the issue of investor knowledge, whether you’re talking about investing in the U.S., farther afield in Europe or emerging markets such as Africa and the Far East. It’s new ground for many, and baby steps may be the best way to go.”

Although fund management companies have typically concentrated on marketing their Canadian products during RRSP season, this year advisors and their clients can expect to hear more about global opportunities, particularly from companies with products in hot emerging markets. For example, CI Mutual Funds Inc. ’s autumn road show is labelled “Global Insights” and offers a handful of managers speaking about the opportunities in global small-caps, Europe, the U.S. and emerging markets.

@page_break@Excel Funds Management Inc. , which sponsors funds investing in India and China, has experienced heightened interest in its funds because of exciting investment performance.
It expects demand to intensify during the upcoming RRSP season. Pierre Daillie, marketing and sales manager at Excel, says the removal of the foreign-content rule means investors no longer need a large self-directed RRSP to make meaningful foreign investments, and he expects more small investors will venture into India and China.

“With the restrictions gone, we expect a more receptive audience for the story unfolding in India and China, and people will be making more liberal allocations,” says Daillie.
“The unlimited room for foreign content offers a business opportunity to advisors, who have a new reason to open discussions with clients and perhaps rejig portfolios a bit. It may be time to take some profits from resources, for example, and put them into some high-growth foreign markets.”

The removal of the foreign-content rule raises questions for fund managers about what constitutes a Canadian equity fund. The Canadian investment funds standards committee defines a regular Canadian equity fund as one with up to 30% foreign content, and a pure Canadian fund as one with 95% Canadian content. The committee is canvassing the industry on the appropriate mix of foreign and Canadian securities for regular funds now that the official limit for regular funds is gone, and is finding a variety of opinions. While some managers think a fund should be invested at least 95% in Canadian stocks to qualify for the Canadian equity category, others prefer the allocation to be left as it is.
Still others think 51% Canadian content is sufficient. The definition is important, as funds are grouped with others that have the same mandate, and are ranked accordingly.

“The issue the committee is grappling with is whether the status quo still works,” says Rudy Luukko, chairman of the CIFSC. He says there will be no changes before RRSP season, but there could be some after the formal category review in May.

If the parameters of a Canadian equity fund are changed for the CIFSC’s classification purposes, it may trigger tax consequences for investors who hold Canadian equity funds outside an RRSP. Capital gains and losses could be crystallized within funds as managers sell some holdings to meet new levels of Canadian and foreign content.

Many Canadian managers will be pleased to have some leeway to increase their foreign content. Some of the larger Canadian equity funds are finding the Canadian market limited in choice and cumbersome for acquiring and unloading large positions; likewise, many small-cap funds could enjoy the greater flexibility and liquidity offered by a bigger universe. David Taylor, manager of Dynamic Value Fund of Canada as well as several other funds within the Dynamic Mutual Funds Ltd. fold, was pushing up against the 30% limit before the rule was abolished. He has since moved toward a 35% foreign component in all of his funds, adding some exposure in Korea, Indonesia, Israel and the U.S.

“I run screens around the world looking for value, and a lot of Canadian stocks have been overpriced as a result of the rules that restricted fund and pension managers primarily to Canada,” he says. “I’ve decided that somewhere between 30% and 40% is now my comfort zone with foreign content.” IE