Christian Chensvold

From our Canadian Bureau: The Retirement Fund Shell Game

Think Canada's only known for its hockey players? Well get a load of this hat trick.

RRSPs (Registered Retirement Savings Plans) are the Canadian equivalent of America's tax-free IRAs. Trouble is, in Canada the government requires you to own 75 percent of your holdings in Canadian companies. This is intended to provide appropriate diversification opportunities for RRSP holders while ensuring that the bulk of their tax-assisted retirement savings is invested domestically. But investors have found a way around this with a neat little shell game involving index funds and "clone" funds that allow the portfolios of Canadians to grow without borders.

A key aspect of the loopholes is understanding that the bulk of money in the fund is not actually held in stocks.

Certain index funds offer Canadians RRSP-eligible, foreign-exposure funds that track the performance of a foreign index, such as the S&P 500. In general, the managers of these funds put over 90 percent of their money in domestic treasuries, and then use futures contracts on the index being tracked in order to replicate its performance. "That gets around the rule because technically the fund is mostly Treasury bills, and the rest is foreign," says the mysterious Mr. Bylo Selhi (that's "buy low, sell high"), who operates a financial Web site at bylo.org. "But because they lever it, they get the same return as if they were buying the S&P index directly."

And because futures are involved, it's possible to hedge currency. So you can buy an index fund that tracks the S&P 500 and which is also impervious to changes in the U.S. dollar. "I don't think that's a good thing," says Mr. Selhi, "but some people are really concerned when the Canadian dollar rises. If it goes up 10 percent and the S&P goes up 20, then they're really upset because their fund really only went up 10 percent and it's supposed to track the S&P." In fact, they may be sacrificing some of the diversification benefit of owning equities exposed to another currency while paying a heavy price to hedge.

Altamira has a number of funds that track U.S. indexes with the combination of underlying treasuries and futures contracts. Its latest funds aimed at RRSP investors looking to skirt the 25 percent cap are the RSP e-business Fund, RSP Science and Technology Fund, and RSP Japanese Opportunity Fund.

Clone funds are the copy cats of the industry. They aim to mimic an underlying foreign fund. This can be done in a number of different ways. Templeton Management Ltd. was one of the first to offer these funds, and they generally work like this: If you invest $1,000 into the clone fund, 25 percent at most (the amount of the current cap) will go into the underlying fund. The rest is deposited with a counterparty, typically a chartered bank. The bank then writes a forward contract to the clone fund in which it agrees to pay the same return as the underlying fund. In a nice dramatic twist, the bank then actually puts the $750 into the underlying fund to ensure it will be able to fulfill its contract with the clone fund.

Many Canadian investors are wary of using index and clone funds for their RRSPs, not because of the derivatives behind them (options, futures and forward contracts), but the fees tacked on because of the contracts involved. The fees can be up to 60 basis points higher than what an investor would pay for a plain vanilla foreign-content or index fund.

Many investment advisers believe that at least 30 percent of your portfolio should be in foreign holdings. As the Canadian government keeps raising the amount of foreign holdings it allows in its RRSPs, perhaps someday the cap will be dropped entirely. The fact that people have found ingenious ways of getting around it is one argument for dropping the cap. Another is recent research which found that the cap doesn't matter, as when foreign-content limits were dropped in the U.S., U.K. and Japan, investors still remained primarily in their home markets.