Solving the home country bias in Canadian portfolios

Canadian investors tend to suffer from home bias – a preference to hold more domestic stocks over foreign equities. This is actually true of investors in most countries, but it’s particularly troubling in Canada where our stock markets are highly concentrated in the financial and energy sectors.

The federal government could be partially to blame for our home bias tendencies. As recently as 2005 the government imposed a limit on the amount of foreign content allowed in RRSPs and pension plans. This cap was introduced in 1971 to help support the development of Canada’s financial markets but was scrapped in the 2005 federal budget, freeing Canadians up to invest abroad.

It’s well known that Canada makes up less than 4 per cent of global equity markets (2.7 per cent, to be exact), yet 60 per cent of the equities in Canadian investors’ portfolios are in domestic securities.

Even most model ETF and index fund portfolios have Canadian investors overweighting domestic equities, holding anywhere from 20 to 40 per cent Canadian content.

The result is a portfolio that is more volatile and less efficient than one with international equity diversification. Indeed, investors with a Canadian home bias are taking risks they could have diversified away by increasing their allocation to global equities.

My two-ETF portfolio

So how does my portfolio stack up? When I switched to my two-ETF solution, made up of Vanguard’s VCN (Canadian) and VXC (All World, ex-Canada), I chose to have an allocation 20-25 per cent Canadian stocks and 75-80 per cent international stocks.

That allocation would be relatively easy to monitor and rebalance if it was simply held in my RRSP. Whenever I added new money to my RRSP, I’d simply buy the ETF that was lagging behind its initial target allocation.

But I complicated things recently when I started contributing again to my TFSA. I wanted to treat my TFSA and RRSP as one total portfolio and keep the same asset mix in place. Since my RRSP was much larger than my TFSA, I decided to hold mostly foreign content (VXC) in my RRSP while putting Canadian stocks (VCN) in my TFSA.

This worked out great for several years but now I’ve run into a second problem; I’m contributing to my TFSA at a much faster pace than my RRSP. That’s because I’ve maxed out all of my unused RRSP contribution room and, due to the pension adjustment, I get a measly $3,600 per year in new contribution room.

Meanwhile I still have loads of unused TFSA contribution room and so I’ve been socking away $12,000 per year for the past two-and-a-half years. I hope to continue at that pace for many more years until I’ve completely caught up on all that available contribution room.

The result is a portfolio that is becoming increasingly more tilted to Canadian equities. At this rate, if I continue filling my TFSA with VCN, my portfolio will have more than 30 per cent Canadian content in five years, and nearly 40 per cent Canadian content in 10 years.

My Home Bias Solution

I’m considering a change to my two-fund portfolio. With the introduction of Vanguard’s new all-equity asset allocation ETF – VEQT – I could turn my two-fund solution into a true one-fund solution and make investing even more simple.

Not so fast, though. When I looked under the hood of VEQT to see the underlying ETFs that it holds, I noticed a heavy tilt towards Canadian equities:

• Vanguard US Total Market Index ETF – 39.1%
• Vanguard FTSE Canada All Cap Index ETF – 30.1%
• Vanguard FTSE Developed All Cap ex North America Index ETF – 23.3%
• Vanguard FTSE Emerging Markets All Cap Index ETF – 7.5%

I don’t want a portfolio made up of 30 per cent Canadian equities. If anything, I want to reduce my exposure to the Canadian market.

Here’s what I’d like to do: Replace VCN with VEQT.

What that means is my RRSP will hold nothing but VXC, while my faster growing TFSA will hold VEQT.

At the end of 2019 my new two-ETF portfolio would look something like this:

Because VEQT is made up of 30 per cent Canadian equities I would have approximately 4.9 per cent of my overall portfolio weighted to Canadian markets (much more aligned with its global weight).

But as I continue making larger TFSA contributions each year the percentage of Canadian content will gradually increase (just less quickly than if I had been contributing straight to VCN each time).

At the end of 2024 my portfolio would look like this:

The Canadian content from my ever-rising VEQT would still make up just 9.4 per cent of my overall portfolio.

By then I’ll have caught up on my unused TFSA contribution room and so I’d only be able to put in the annual TFSA maximum.

The growth of VEQT as a percentage of my overall portfolio slows, and so the percentage weighted to Canadian equities only creeps up to around 12 per cent by the year 2040.

Final thoughts

I want to tame my home bias for Canadian equities while keeping my portfolio as simple as possible.

By replacing the Canadian equity ETF (VCN) with the new Vanguard 100 percent equity asset allocation ETF (VEQT) I’m able to keep my simple two-fund solution intact.

Meanwhile I solve a potential diversification problem by reducing my home bias to Canadian stocks and maintaining proper global diversification inside my portfolio.

In addition to running the Boomer & Echo website, Robb Engen is a fee-only financial planner. This article originally ran on his site on March 4, 2019 and is republished here with his permission.