February 2000

Clone Funds Open RRSPs
to World of Global Equities

© Talbot Stevens

Most Canadian investors are fully aware of the negative impact that the 20-percent foreign content rule has had on their RRSPs.

With the Canadian stock market representing less than 3% of the equity opportunities around the world, restricting RRSPs to such a small sliver of the global pie hurts investors in two ways.

Forcing investors to keep almost all of their savings in their own country reduces economic, political, and currency diversification which naturally increases risk.

The more visible issue related to restrictive RRSP foreign content limits is returns, or more accurately, the potential for higher returns. Annual global equity returns have historically averaged about 2 to 3% higher than Canadian equities. The difference, which we might call the global equity premium, has been closer to 5% over the last decade.

If a 3% increase in annual returns seems insignificant, an example helps illustrate the difference compounded over time. $10,000 invested at a 9% return grows to $133,000 after 30 years. Averaging a slightly higher 12% return produces $300,000 — more than twice as much.

For years, mutual funds have offered a way around the 20% foreign content rule to allow investments in international markets to be 100% RRSP eligible. These funds use derivatives to clone or mimic the returns of foreign market indices, like the S&P 500.

In 1999, the concept was extended to clone individual foreign equity mutual funds. Now, RRSP-eligible clones of the most popular international funds are available and have been an instant hit with Canadian investors.

Before you jump on the clone fund bandwagon, several issues should be considered.

Investors should not expect the RRSP clone to perfectly match the returns of the original fund for two reasons.

RRSP access to global equity funds does not come free. The overhead of using derivatives increases the cost of these funds by about 0.4 to 0.6% per year.

Additionally, the derivative approach does not allow perfect tracking of the underlying fund, and there will be some amount of tracking error.

How much foreign content do you want? Studies show that between 40 and 60% foreign content provides the optimal balance for increasing returns and lowering risk.

Not all investors will be comfortable with these new derivative-based solutions with little track record. Now that the government has indicated that higher foreign content limits will be phased in soon, will clones be necessary?

Finally, we should realize that Canada is still largely an “old industry”, resource-based economy that does not offer the growth prospects of newer technology-based businesses. Getting more global exposure can only benefit most long-term investors.

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