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Foreign content limit scrapped
Change sparks questions

In a surprise move, the Federal Government's annual budget lifted the cap on foreign property holdings in RRSP, pension, and other tax-deferred savings plans. This is great news, but sparks many important questions.

What will happen to clone funds?

Clone funds is a generic term often applied to all funds using derivatives to effect exposure to foreign securities while 'counting' as Canadian content. However, there are two noteworthy types of such funds.

Index futures funds are those employing exchange-traded futures contracts to mimic the performance of a recognized stock index - i.e. S&P 500. These have been in existence since about 1992.

Clone funds were created as fully RRSP eligible versions of similar actively managed funds. They debuted with a rather awkward structure shortly after index futures funds began but a more elegant structure emerged around 2000. Such funds use forward and swap contracts to track underlying foreign funds.

These funds were created to effectively skirt the foreign content limits. Hence, the termination of such limits should effectively mean the extinction of such funds. Some index futures funds may well remain, particularly since they don't cost any more than regular index funds. But the clone structure is costly and this is now unnecessary.

It will take some time for clone funds to unwind the forwards and swaps but fund companies are likely to start planning this now in preparation of the budget being passed into law later this year. At the end of the day, clones are likely to be merged into the respective underlying foreign funds they were designed to track.

As an aside, the Liberal party's minority status probably means most should proceed with caution on this rule - i.e. waiting until it's officially passed into law.

Will Canadian equity funds still hold foreign content?

Probably, yes. Canada is a small market, so being able to shop outside of our borders is a big benefit for managers for two reasons. First, strong price appreciation over the past couple of years has left fewer bargains. Second, some funds are so big, they need to look outside of Canada to find enough stocks that are both worth buying and liquid enough to allow meaningful positions to be accumulated.

So, I expect little to change here since many funds don't fully maximize their foreign content use anyway.

How will Canadian market be impacted?

While the industry has long been lobbying for lifting the foreign content limit, those against this change argued that we'd see huge flows of capital leave Canada. But I think the government's timing couldn't have been better to calm such fears.

With foreign stocks sporting unimpressive performance over the past five years and Canadian stocks - particularly income trusts - coming off a huge five year run, it's unlikely that Canadians will rush to park large amounts of money in securities outside of our borders. Sure, pension funds may take greater advantage of this, but they're so big they've long had direct access to index futures to gain quick and efficient foreign exposure.

Supporting my view here is the fact that mutual fund investors have been pulling money out of foreign stock funds at a record pace. Sure, some funds like Mackenzie Cundill Value and Brandes Global Equity are raking in strong net sales, but most are bleeding as investors shift heavier into yield-oriented securities and funds investing in the same.

What changes should investors make?

In structuring portfolios, I often found the 30% limit to be quite sufficient in most cases. Hence, I suspect that investors won't really need to make major adjustments as a result of this change. However, with overseas markets - particularly Europe, Japan, and some emerging markets - looking attractive, this may be just the time to make sure your portfolio has a sufficient amount of overseas exposure.

Other issues worth noting is that trustees that continue to charge for self-directed RRSP accounts may now have a tougher time justifying their fees. See, they would always argue that they had to track book values for foreign content purposes. But once the foreign limit no longer applies, what is it they'll be charging for?

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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