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By Som Seif
Special to the Financial Independence Hub
Many, even most, Canadian investors suffer from a bias by which they invest in what they know: home.
This is short-sighted and dangerous for an investor’s portfolio, as the Canadian market is very small and concentrated in comparison to the U.S., especially around three primary sectors. Canadians really don’t have to go away to far flung places for diversification – they only need to look southward to the U.S. market, which is one of the broadest, deepest and most liquid financial markets in the world.
For those considering investing in the U.S., really focus on these three areas that are the core to growing and diversifying an investment portfolio.
- Go for the big treasure chest of companies. Go for diversity.
Don’t be afraid to go big. What really makes the U.S. marketplace interesting and attractive to investors is its size, liquidity and diversity. Over 20 per cent of the world’s gross domestic product comes from the U.S.[1], while over one third of the world’s market capitalization of companies is there too.[2]
This is why some of the biggest companies in the world still list in the U.S., even when much of their revenues come from outside the U.S. So when people talk about investing in the U.S., we are primarily talking about investing in some of the world’s largest and greatest businesses.
- Don’t let taxes deter you. Be thoughtful about it.
Be thoughtful about how taxes affect investment returns. When we buy a Canadian company and it rises in value, on selling we will pay capital gains tax at a lower rate than is charged on interest income, which is great. But we also get a tax credit on dividends. So our dividends become a little more attractive on an after-tax basis. The benefit of the dividend tax credit is often the primary reason why Canadians stick to Canadian companies.
On the other hand, with U.S. stocks, we also get taxed on capital gains, which can be a really hard hit on an investor’s returns. But U.S. dividends don’t benefit from the lower tax rate enjoyed by Canadian stocks, and also have a small withholding tax applied to them. So U.S. stocks, generally, are slightly less tax efficient for Canadian investors.
That said, the benefits of accessing a much deeper universe of great companies and broad sector diversification meaningfully outweigh the tax differences. And there is some value in being thoughtful about where to best buy Canadian stocks and where to use U.S. stocks to complement your Canadian stocks. For example, when there is a global multinational company in Canada, providing generally the same opportunity in our marketplace as it would be in the U.S., it’s worth using the Canadian company.
A great example of this is the insurance space, where Canada has some of the best global operators with companies such as Manulife and Sun Life. When you compare apples to apples in this space, there is little additional benefit to allocating to U.S. insurance companies and you can get a high tax-efficient dividend and total return at home. Complementing these great Canadian companies with a broad set of U.S. companies in areas such as technology, consumer products, real estate, health care, which are sectors with very little exposure to in Canada, can be very powerful.
- “Currency risk” is a consideration, but not a deterrent
When you decide to buy a U.S. stock based on its fundamental attractiveness, two factors come into play for Canadians. One is the price of the stock, where your thesis of strong fundamental opportunity may result in a nice capital gain. The second factor is the change in the currency level between Canadian dollar and U.S. dollar. While you might be right about where the stock goes, if the Canadian currency depreciates against the U.S. dollar, you have a factor that could potentially affect your returns dramatically.
In my opinion, this factor is really only relevant if we are investing with a short time frame. If you are a 10- or 20-year investor in equities, then I believe the additional exposure to currencies actually acts as a benefit to your investments. Through long-term economic cycles, currency changes often stabilize or normalize. But they can add a significant volatility dampener for your equity returns.
The key takeaway in all of this is that there are investment options based on your preferences when investing in the U.S. Whether you want to have U.S. dollar currency exposure or not, there are wonderful product solutions in the ETF and mutual fund space today that offer both currency-hedged and non-hedged exposures. That way, you can invest in the U.S. and currency risk should not deter you from making the allocation.
[1] https://www.quandl.com/collections/economics/gdp-as-share-of-world-gdp-at-ppp-by-country
[2] https://www.ftportfolios.com/Commentary/MarketCommentary/2014/10/21/u.s.-equities-share-of-total-global-market-capitalization-is-growing
Som Seif is the founder and Chief Executive Officer of Purpose Investments Inc., which he formed following the sale of Claymore Investments to BlackRock Inc. in March 2012. Prior to Claymore, he was an investment banker with RBC Capital Markets. Som’s goal is to make investing for Canadians cheaper and better.
