Foreign Investing – Is It for You with the Higher Risks?
August 2015
Many advisers recommend investing a substantial portion of your portfolio outside of Canada. There are number of reasons for doing this. First, the Canadian stock market makes up less than 3% of the world markets; therefore, over 97% of opportunities are outside of Canada. Second, investing outside of Canada enhances your ability to diversify geographically. Third, there will be individual companies that provide very good income and growth opportunities to you that are located in foreign countries. And, I am sure there are other good reasons as well.Unfortunately, mutual fund commissions are higher on foreign funds than they are on domestic funds, so they may be pushed your way by a biased advisor.
I am a big fan of diversification. However, I always have concerns about buying any kind of property or investment in a location that is beyond the scope of my ability to monitor it. By that, I mean that I want to understand the environment and the property or company in which I am going to invest. I would not buy land without seeing it first because it could be a swamp. I would also not buy land without investigating the local area because, although it may be a prime piece of real estate, maybe it is about to be zoned for a freeway. I would want to monitor future changes after my purchase, so if there is talk of a new freeway in the area, I can sell before the land devalues. In Canada, I have much more opportunity to investigate such things; not so much in a faraway country.
Therefore, my advice when investing outside of Canada is to think carefully before doing so. Certainly, our neighbour to the south is much safer than going further afar. However, you still have the risk of major currency swings impacting your investment values. If you invest $1,000 US in a company when the Canadian dollar costs $1.25 in US dollars, your cost is $1,250 Canadian, which is obviously the same as its market value at that time. In the future, assuming no purchases or sales of that stock, your cost in US dollars is still the equivalent of $1,250 Canadian. Assume that the value of the company remains unchanged at $1,000 U.S. However, what if the Canadian dollar strengthens, and, for example, returns to par with the US dollar? The value of your stock in Canadian dollars will decline to $1,000 even with no change in the value of the company. If you sell at that time, you will have an investment loss of $250, or 20%, even though the value of the individual company did not change. This loss is solely due to foreign exchange fluctuations. Of course, this can also work in your favour if the Canadian dollar weakens. When investing in the United States (or any other foreign country), you need to consider the prospects for changes in the underlying investment value as well as the direction of changes in the foreign currency value.
If you are investing in individual companies overseas, then you need to ensure that you are monitoring these companies, evaluating their performance and their risk exposures. For Canadian companies, this is much easier by listening to the local news, using investment reporting services, using Internet services, etc. Formal financial reporting (i.e. annual and semi-annual reports) may be more difficult with foreign companies. They may not be subject to the same rigorous reporting requirements as we have in Canada. How will you, or your investment advisor, monitor these companies? I suspect even professional money managers have significant challenges.
Political stability and government control in some countries may also be questionable. Is there a possibility that your investment in a company may be lost because of a government takeover? Perhaps you have an investment in a utility that is privately run, but is then taken over by the government without fair payment to the shareholders. Or, your investment may be operating in a country that encounters financial problems. Significant cutbacks in government contracts or significant increases in tax rates could have a major impact on your investment. Also, changes to government legislation may impact the company. With issues such as these, the value of the entire stock market in that country could be impacted, which could deal a significant blow not only to individual companies, but also to mutual funds that have invested heavily in that region.
One of my corporate clients many years ago was looking to expand internationally. They were investigating the purchase of a company in a foreign country. The initial financial reports looked good, but they found out otherwise when doing their due diligence at the company location. The culture in this particular country supported many illegal activities, including payment of bribes to government officials and “under the table” transactions that were not reported. My client discontinued negotiations because they could not determine whether this company would be successful or not, nor would they be able to trust local management to operate the company appropriately.
We struggle with biased financial reporting and illegal activities in North America. Remember Nortel, Enron and WorldCom? We have seen government legislation have significant impacts on investments within Canada, such as when the federal government changed the taxation on income trusts, resulting in significant devaluations overnight. I am not saying that you should not invest outside of Canada. However, I am saying that you need to be aware of the increased risks and take appropriate steps to monitor them.
If you would like some exposure to foreign markets, and are concerned about the above risks, explore other opportunities with your investment advisors. Certain Canadian companies are multinationals. They have significant operations in other countries, which will give you some exposure, but with risks likely better managed. Use of Exchange Traded Funds or mutual funds will avoid the risk of investing in individual companies. Some funds use currency hedging techniques to protect against foreign exchange losses, but these techniques are complex and need to be implemented correctly. If I am worried about an increase in the value of the U.S. dollar, I can buy some U.S. money now, or I can sign an agreement to buy some in the future at a price determined now. What if the dollar goes in the other direction? I confess I do not understand currency hedging any more that that – and if I do not understand something, I tend to avoid it.
Before closing, I want provide a few tax planning considerations for foreign holdings. First, dividends paid by foreign companies are taxed at the same rates as interest income, whereas Canadian dividends receive a lower tax rate because of a dividend tax credit. next, dividends paid from US stocks to an RRSP are exempt from US tax withholdings by international treaty, but payments to a TFSA are not. Hence, you should not buy US dividend paying stocks in a TFSA. Foreign income is taxed based on agreements between governments, and can vary by country. If you have any foreign withholding taxes on stocks in your RRSP or a TFSA, speak to your broker promptly. You will not be eligible for a foreign tax credit, and hence be double taxed.
When reporting the sale of foreign stocks in your regular investment accounts, remember to calculate your capital gain or loss using (a) the original cost of the stock in Canadian dollars converted at the foreign exchange rate on the original date of purchase (not on the date of sale), and (b) the selling price, less commissions, converted at the time of sale. If your investment advisor does this for you, check a few calculations to ensure they are done correctly.
Finally, I am not trying to scare you away from foreign investing. Understand the risks, and I encourage you to diversify internationally – just do not go overboard with more risk than you can withstand. Invest wisely. It is your money, and you will be responsible for any losses, regardless of whose advice you follow. If you cannot afford to lose some money, look for safer alternatives than the stock market.
Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum