When investing your money, it’s important to diversify your investment into different types of assets (such as stocks, bonds and real estate), different segments of the stock market (such as financials, consumer staples, utilities, technologies, telecommunications, etc.) and different regions of the world (such as North America, Europe, Asia, etc.). However, for a small and insignificant Canadian retail investor like me, being able to do all of these will be quite challenging. First of all, direct access to international markets is very limited for retail investors. Secondly, having access to information and the knowledge to interpret that information on the international market (and foreign language) may proof to be too resource intensive and difficult for the average investor like me. Based on these two factors, I decided to stay within the Canadian and U.S. stock markets and only invest in the markets that I know. Since I am a Canadian, understanding the Canadian market is easy, but to venture into the U.S. market requires a bit of work. In this post, I will list some of the challenges that Canadian retail investors face when investing in the U.S. stock market. By overcoming some of these challenges, you’ll lower your investment risk, keep more of your money and improve your U.S. investment returns.
Foreign Dividend Withholding Tax
When you (assuming that you are Canadian) invest in the U.S. stock market, you will be classified as a foreign investor based on U.S. laws. If any of your U.S. stock pays you a dividend, then the dividend will be subject to a foreign dividend withholding tax. This tax amounts to 30% of your total dividend, which really sucks when they take almost 1/3 of your dividend income. However, there is some good news to this as the Canadian and U.S. governments have a tax treaty, which would allow investors from both countries to pay less withholding taxes or no withholding taxes depending on which account the foreign stock is held. For Canadians, if your U.S. stocks are held in any retirement-related accounts such as RRSP, LIRA, RRIF or LIF, you don’t pay any withholding tax (you get to keep 100% of the dividend). If your U.S. stocks are held in non-retirement related accounts, you can fill out the “W-8BEN” form and have your investment brokerage submit it to the U.S. government on your behalf to lower the foreign dividend withholding tax from 30% to 15%. Furthermore, if you hold U.S. stocks in your non-registered account, you’ll get to claim a foreign dividend tax credit on your income tax. As for accounts like TFSA and RESP, the best case scenario is just getting the lower 15% foreign dividend withholding tax and nothing else.
Currency Risk And Hedging
When you invest in a foreign country, you’ll definitely have to convert some of your money from your country’s currency to the foreign country’s currency. For Canadians to convert our Loonie (CAD) to the Greenback (USD) or vice versa, the conversion cost is about 0.25% of the market rate, which is quite reasonable comparing to other currency pairs. To lower the currency risk, I use a few methods. The first method is to buy a U.S. index ETF such as the iShares S&P 500 Index Fund CAD Hedged (XSP) that holds U.S. stocks, but it’s priced in the Canadian dollar. This ETF will put in a USD to CAD hedge to make sure that the fluctuation in the currency market has minimal effect on the return of this ETF. So, on an annual basis, it costs this ETF about 0.25% to minimize the currency risk and the return of this ETF will almost mirror the S&P 500 Index. The second method that I use to lower my currency risk is to buy my U.S. stocks using my margin account. This way, I don’t convert any of my CAD funds to USD when I buy or sell my U.S. stocks and only the capital gain or loss portion of my U.S. stocks are subject to currency risk. The third way to lower my currency risk is to convert the currencies when the exchange rate is favourable from my perspective. For example, in 2011 when the CAD to USD exchange rate is $1 CAD to 1$.05 USD, I started to convert my CAD to USD. In early 2015, when the CAD started tanking, the USD to CAD exchange rate was about $1 USD to $1.25 CAD and I started to re-patriot some of my USD back to CAD. Let’s say that back in 2011, I converted $10,000 CAD to USD. So I got $10,500 USD after the conversion in 2011. Now forward to 2015, I converted my $10,500 USD back to CAD and got $13,125 (=$10,500*1.25). As a result of those opportunistic conversions, I made 31.25% (=[13,125-10,000]/10,000) in currency gains.
Increasing Your Income Tax Efficiency
If you have been reading my other posts, you’ll definitely come across the topic of income tax somewhere in those posts. So I don’t think this post will be complete if I don’t cover the income tax aspect of this investment strategy. First of all, the most efficient account to hold your highest dividend paying U.S. stocks is your retirement-related accounts (RRSP, LIRA, RRIF, LIF). When you hold U.S. stocks in there, you won’t be paying any foreign dividend withholding tax and the dividends and capital gains are taxed sheltered. The next best account to hold U.S. growth stocks is the non-registered account. Since growth stocks pay minimal to no dividends, you don’t have to worry too much about the withholding tax. In addition, you can use the margin account to lower your currency risk and convert your currency with more flexibility when the opportunity arises. The drawback for holding U.S. stocks in your non-registered account is the income tax treatment of dividends. Foreign dividends are being discriminated against and don’t get the same preferential tax treatment as Canadian dividends – they are being taxed as regular income. Lastly, the least efficient accounts to hold U.S. stocks are the TFSA and RESP accounts. Though they are registered accounts, they are not retirement related and the size and movement of funds in those accounts are quite restricted. It’s best to buy U.S. index ETF with currency hedges like XSP in those accounts.
My two cents
To ensure that my investments are well diversified and to reap the benefits that are tied directly to the economy of our closest neighbour to the south, investing in the U.S. stock market was a simple choice. However, with any investment en devour, there is always a level of risk and complexity that comes with it. To ensure that I put myself in the best position to succeed (and to make money), investigating and understanding the major risks and allocating my investments to the right vehicles and accounts will give me a head start. The ultimate key to any successful investment is to only invest in what you know.
So what is your approach to diversifying your investments?