The short answer is currency risk and tax efficiency. Both are much more important than many investors realize, especially if you’re building a DIY portfolio in a tax-free savings account (TFSA). These two factors go a long way to explaining why Canadian stocks punch well above their weight in Canadian portfolios, and why they should continue to be an important core investment for most investors.
Below we take a closer look at all of them, followed by one Canadian ETF that fits this role well for BMO Global Asset Management.
Currency risk
When you invest outside Canada, whether in the US or in international stocks, you generally introduce currency exposure. That means your returns are affected not only by how the underlying stocks perform, but also by how the Canadian dollar moves against foreign currencies.
Sometimes that works to your advantage. A weaker Canadian dollar could boost returns on foreign investments. Other times it hurts. A stronger fool could offset solid market performance elsewhere. Over longer periods, currency effects tend to level off, but in the short and medium term they can create volatility that has nothing to do with the quality of the investment itself.
By owning Canadian stocks denominated in Canadian dollars, you remove that variable completely. You don’t have to worry about currency conversion and dragging or boosting foreign exchange. For investors with a shorter time horizon, or for investors who simply prefer fewer moving parts, that simplicity can be valuable.
Tax efficiency
Tax efficiency is where Canadian stocks really stand out for Canadian investors.
In non-registered accounts, many Canadian companies pay eligible dividends, which benefit from the dividend tax credit. This makes them more tax efficient than dividends from U.S. or international stocks, which do not qualify for the same treatment.
Even within a TFSA, where most income is safe, US dividends face a notable exception. Dividends from US stocks or US-listed ETFs are subject to a 15% withholding tax, levied at source. There is no way to fix this within a TFSA. That reduces the amount you can reinvest or spend.
Canadian stocks and ETFs that hold Canadian stocks do not face this problem. Dividends are received in full, allowing maximum compounding within the TFSA or tax-free withdrawals when you need the income.
A Canadian ETF that fits this role
One Canadian ETF I have a soft spot for is the BMO S&P/TSX Capped Composite Index ETF (TSX:ZCN)
For a very low expense ratio of 0.06%, or about $6 per year on a $10,000 investment, it offers exposure to more than 250 Canadian stocks representing the broad domestic market.
The ‘capped’ structure means that no share can exceed a weighting of more than 10%, which helps limit concentration risk while allowing larger companies to play a meaningful role.
The ETF also offers a solid 2.2% annualized return with quarterly distributions. Most of that income comes from eligible Canadian dividends, making it well suited for a TFSA from a tax perspective.
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