International Diversification for Canadian Investors

The Case for Looking Beyond Canadian Borders

Canadian investors often exhibit a strong home bias, concentrating their portfolios heavily in domestic markets. While familiarity with local companies and economic conditions can provide comfort, this approach creates significant limitations from a diversification perspective. The Canadian market represents less than 3% of global market capitalization and is heavily concentrated in a few sectors—financials, energy, and materials account for approximately 60% of the S&P/TSX Composite Index.

This article examines why international diversification is essential for Canadian investors, explores various approaches to global investing, and provides practical strategies for building a truly diversified portfolio that extends beyond Canada's borders.

The Limitations of a Canada-Only Portfolio

Size and Scope Constraints

The Canadian equity market is relatively small on the global stage. With a market capitalization representing less than 3% of the MSCI All Country World Index, limiting investments to Canadian securities means missing out on 97% of global investment opportunities. This limitation becomes particularly significant when seeking exposure to sectors like technology, healthcare, and consumer discretionary, which are underrepresented in the Canadian market.

Sector Concentration Risk

The S&P/TSX Composite Index exhibits significant sector concentration:

• Financials: approximately 30-35%
• Energy: approximately 15-20%
• Materials: approximately 10-15%

This concentration creates vulnerability to sector-specific downturns. For example, during oil price collapses (as seen in 2014-2015 and 2020), the heavy energy weighting can significantly impact portfolio performance. Similarly, financial sector stress can disproportionately affect Canada-only portfolios.

Economic Correlation

Canada's economy, while stable, is heavily influenced by specific factors:

• Commodity prices (particularly oil, gas, and metals)
• Housing market conditions
• United States economic trends (Canada's largest trading partner)
• Canadian dollar fluctuations

A portfolio concentrated in Canadian assets will be significantly exposed to these specific economic drivers, potentially increasing volatility during certain economic cycles.

Benefits of International Diversification

Enhanced Risk-Adjusted Returns

Academic research consistently demonstrates that internationally diversified portfolios tend to produce better risk-adjusted returns over the long term. By including investments that respond differently to economic conditions, market cycles, and regional events, investors can potentially achieve:

• Lower overall portfolio volatility
• Improved Sharpe ratios (return per unit of risk)
• More consistent performance across different market environments

Access to Growth Opportunities

International diversification provides exposure to:

• Emerging markets: Economies like China, India, Brazil, and Southeast Asian nations often exhibit higher growth rates than developed markets, driven by favorable demographics, increasing middle-class consumption, and infrastructure development.
• Innovative sectors: Technology giants, healthcare innovators, and consumer brands often have limited representation in Canada but are abundant in markets like the U.S., Europe, and Asia.
• Unique business models: Different regions have developed distinctive business models that respond to local market conditions and consumer preferences.

Currency Diversification

Holding investments denominated in multiple currencies can provide an additional layer of diversification. Currency fluctuations can either enhance or detract from returns in any given period, but over the long term, currency diversification can help mitigate the impact of Canadian dollar volatility on a portfolio.

During periods of Canadian dollar weakness (often correlated with falling commodity prices), international investments can provide a valuable hedge. Conversely, when the Canadian dollar strengthens, domestic investments may outperform.

International Investment Vehicles for Canadian Investors

Exchange-Traded Funds (ETFs)

ETFs represent one of the most accessible and cost-effective ways for Canadian investors to gain international exposure:

Broad International ETFs

• iShares Core MSCI EAFE IMI Index ETF (XEF): Developed markets excluding North America
• Vanguard FTSE Developed All Cap ex North America Index ETF (VIU): Developed markets excluding North America
• BMO MSCI All Country World ex Canada Index ETF (ZWC): Global exposure excluding Canada
• iShares Core MSCI All Country World ex Canada Index ETF (XAW): Global exposure excluding Canada

U.S. Market ETFs

• Vanguard S&P 500 Index ETF (VFV): Large-cap U.S. stocks
• iShares Core S&P U.S. Total Market Index ETF (XUU): Broad U.S. market exposure
• BMO S&P 500 Index ETF (ZSP): Large-cap U.S. stocks

Emerging Markets ETFs

• iShares Core MSCI Emerging Markets IMI Index ETF (XEC): Broad emerging markets exposure
• Vanguard FTSE Emerging Markets All Cap Index ETF (VEE): Diversified emerging markets
• BMO MSCI Emerging Markets Index ETF (ZEM): Large and mid-cap emerging markets stocks

Regional and Country-Specific ETFs

• iShares MSCI Japan ETF (EWJ): Japanese market exposure
• Franklin FTSE Europe ETF (FLEE): European market exposure
• iShares MSCI India ETF (INDA): Indian market exposure

Mutual Funds

Actively managed mutual funds provide professional management and can offer advantages in certain international markets, particularly those with less efficiency or transparency:

Global Equity Funds

• Fidelity Global Innovators Class
• RBC Global Equity Fund
• Mawer International Equity Fund
• Mackenzie Ivy Foreign Equity Fund

Emerging Markets Funds

• TD Emerging Markets Fund
• Fidelity Emerging Markets Fund
• RBC Emerging Markets Equity Fund

Direct International Stocks

For investors comfortable with individual security selection, direct ownership of international stocks offers maximum flexibility:

U.S.-Listed Stocks

Canadian investors can easily purchase shares of U.S. companies through most Canadian brokerages. Major U.S. stocks offer exposure to multinational operations and global revenue streams. Examples include:

• Technology: Apple, Microsoft, Alphabet, Amazon
• Healthcare: Johnson & Johnson, UnitedHealth Group
• Consumer: Procter & Gamble, Coca-Cola, McDonald's
• Financial: JPMorgan Chase, Visa

American Depositary Receipts (ADRs)

ADRs represent shares in foreign companies but trade on U.S. exchanges in U.S. dollars, making them accessible to Canadian investors. Examples include:

• Taiwan Semiconductor Manufacturing (TSM)
• Alibaba Group (BABA)
• Toyota Motor Corporation (TM)
• Unilever (UL)

Direct Foreign Market Access

Some Canadian brokerages offer direct access to international exchanges, allowing investors to purchase stocks in their local markets. This approach may involve additional complexities, including foreign exchange considerations, different trading hours, and potentially higher transaction costs.

International Real Estate

International real estate exposure can be gained through:

• Global REITs: iShares Global Real Estate Index ETF (CGR)
• Global Real Estate Mutual Funds: CIBC Global Real Estate Fund
• Individual International REITs: Available as direct stocks or ADRs

Currency Considerations in International Investing

Currency Impact on Returns

When Canadian investors purchase foreign investments, they are implicitly taking positions in foreign currencies. Currency fluctuations can significantly impact returns:

• If the Canadian dollar weakens against a foreign currency, the value of investments denominated in that foreign currency will increase when converted back to Canadian dollars
• If the Canadian dollar strengthens, the value of foreign investments will decrease when converted back to Canadian dollars

Hedged vs. Unhedged Investments

Many international ETFs and mutual funds are available in both hedged and unhedged versions:

Currency-Hedged Funds

• Advantages: Removes currency fluctuation impact, isolating the performance of the underlying investments
• Disadvantages: Hedging costs reduce returns over time (typically 0.1-0.3% annually), and eliminates the diversification benefit of currency exposure
• Examples: iShares S&P 500 Index ETF (CAD-Hedged) (XSP), BMO S&P 500 Hedged to CAD Index ETF (ZUE)

Unhedged Funds

• Advantages: Full currency diversification benefits, no hedging costs, potential for enhanced returns during CAD weakness
• Disadvantages: Greater short-term volatility, potential for negative currency impact during CAD strength
• Examples: Vanguard S&P 500 Index ETF (VFV), iShares Core MSCI EAFE IMI Index ETF (XEF)

Strategic Approach to Currency Exposure

Most long-term investors benefit from maintaining primarily unhedged international exposure for several reasons:

• Currency fluctuations tend to even out over long time horizons
• Unhedged exposure provides true diversification benefits
• Hedging costs create a drag on returns
• CAD weakness often coincides with stress in commodity markets, making unhedged foreign exposure a natural portfolio hedge

However, investors approaching retirement or with specific near-term Canadian dollar liabilities may benefit from partial hedging to reduce currency volatility.

Building an Internationally Diversified Portfolio

Asset Allocation Frameworks

Several approaches can guide international allocation decisions:

Market Capitalization Weighting

Allocating according to global market capitalization would result in approximately:

• 55-60% U.S. markets
• 25-30% Developed international markets (Europe, Japan, Australia, etc.)
• 10-15% Emerging markets
• 2-3% Canadian markets

This approach provides true global diversification but results in a very small allocation to Canada, which may not be comfortable for many Canadian investors.

Home Country Bias-Adjusted Weighting

A more practical approach for many Canadian investors incorporates a moderate home country bias:

• 20-30% Canadian markets
• 40-45% U.S. markets
• 20-25% Developed international markets
• 5-10% Emerging markets

This framework acknowledges psychological comfort with domestic investments while still providing substantial international diversification.

Risk-Factor Based Allocation

More sophisticated investors may allocate based on exposure to global risk factors rather than geography alone:

• Growth vs. value styles
• Large-cap vs. small-cap
• Cyclical vs. defensive sectors
• Commodity sensitivity
• Interest rate sensitivity

This approach focuses on creating a balanced exposure to different economic drivers rather than specific regional allocations.

Sample Portfolio Allocations

Conservative International Portfolio (Higher Canadian Bias)

• 30% Canadian Equity: iShares Core S&P/TSX Capped Composite Index ETF (XIC)
• 35% U.S. Equity: iShares Core S&P U.S. Total Market Index ETF (XUU)
• 25% International Developed Markets: iShares Core MSCI EAFE IMI Index ETF (XEF)
• 5% Emerging Markets: iShares Core MSCI Emerging Markets IMI Index ETF (XEC)
• 5% Global Real Estate: iShares Global Real Estate Index ETF (CGR)

Balanced Global Portfolio

• 25% Canadian Equity: 15% Vanguard FTSE Canada All Cap Index ETF (VCN) + 10% individual Canadian dividend stocks
• 40% U.S. Equity: 30% Vanguard S&P 500 Index ETF (VFV) + 10% individual U.S. growth stocks
• 20% International Developed Markets: Vanguard FTSE Developed All Cap ex North America Index ETF (VIU)
• 10% Emerging Markets: BMO MSCI Emerging Markets Index ETF (ZEM)
• 5% Global Real Estate: CI First Asset Global REIT ETF (RIT)

Growth-Oriented Global Portfolio

• 20% Canadian Equity: BMO S&P/TSX Capped Composite Index ETF (ZCN)
• 35% U.S. Equity: 20% Vanguard S&P 500 Index ETF (VFV) + 15% technology and healthcare sector ETFs/stocks
• 25% International Developed Markets: 15% iShares Core MSCI EAFE IMI Index ETF (XEF) + 10% country-specific ETFs (Japan, Germany, UK)
• 15% Emerging Markets: 10% Vanguard FTSE Emerging Markets All Cap Index ETF (VEE) + 5% individual emerging market leaders
• 5% Global Thematic: Clean energy, cybersecurity, or other thematic ETFs

Implementation Strategies

Core-Satellite Approach

This popular strategy combines broad market exposure with targeted positions:

• Core holdings (70-80%): Broad-based, low-cost index ETFs covering major global regions
• Satellite positions (20-30%): Targeted investments in specific countries, sectors, or individual companies with growth potential

This approach provides diversification through the core while allowing for some personalization and potential outperformance through satellites.

Dollar-Cost Averaging Into International Markets

For investors new to international investing, gradually building positions through regular contributions can help mitigate timing risk and psychological barriers:

• Set a target international allocation
• Implement 25% of the target initially
• Dollar-cost average the remaining 75% over 6-12 months
• Rebalance annually to maintain target allocations

Tax-Efficient Placement

Consider the tax implications when deciding which accounts to use for international investments:

• RRSP: Ideal for U.S. investments due to tax treaty benefits eliminating withholding taxes on dividends
• TFSA: Good for higher-growth international investments where dividend yield is lower (withholding taxes on foreign dividends cannot be recovered in a TFSA)
• Non-registered accounts: Can claim foreign tax credits for withholding taxes on international investments

Challenges and Considerations

Behavioral Challenges

International investing introduces several behavioral challenges:

• Home country bias: The psychological preference for familiar domestic investments
• Regret aversion: Fear of underperforming domestic markets in the short term
• Media influence: Greater exposure to domestic financial news creates recency bias
• Performance chasing: Tendency to overallocate to recently outperforming regions

Overcoming these biases requires understanding their existence and committing to a disciplined, long-term approach.

Political and Regulatory Risks

International investing introduces exposure to different political and regulatory environments:

• Political instability or policy changes in foreign markets
• Regulatory frameworks that may provide less investor protection
• Geopolitical tensions affecting specific regions
• Trade policies and tariffs

These risks can be mitigated through diversification across multiple countries and regions rather than concentrated exposure to a single foreign market.

Monitoring and Rebalancing

An internationally diversified portfolio requires periodic review and rebalancing:

• Annual or semi-annual review of regional allocations
• Rebalancing when allocations drift significantly from targets (typically ±5%)
• Reassessment of international allocation strategy as life circumstances and goals evolve

Conclusion

While the Canadian market offers many quality investment opportunities, limiting a portfolio to domestic securities creates unnecessary concentration risk and foregoes the benefits of true global diversification. International diversification provides Canadian investors with exposure to a broader range of economic drivers, industries, and growth opportunities while potentially reducing overall portfolio volatility.

The proliferation of low-cost ETFs, mutual funds, and online brokerage platforms has made international investing more accessible than ever for Canadian investors. By thoughtfully incorporating global investments across developed and emerging markets, investors can build more resilient portfolios designed to weather various economic conditions and capitalize on global growth trends.

The optimal international allocation will vary based on individual circumstances, time horizon, and risk tolerance, but most Canadian investors would benefit from significantly more global exposure than the average self-directed portfolio currently maintains. Starting with a modest international allocation and gradually increasing it over time can help overcome psychological barriers while enhancing long-term portfolio outcomes.