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Why should some of my mutual funds be invested in foreign markets?

Since Canada is a small player in world markets, accounting for less than 3% of world stock market value, it's important to diversify internationally. Holding stocks from around the world gives you more opportunity to reduce risk and boost returns. World stock markets, and niches within those markets, tend to perform differently from our markets and also from each other.

However, you should be mindful of the risks of international investing. You could encounter political and economic instability or natural disasters. At the same time, some foreign stock markets are not regulated or monitored in the same way as in Canada and the United States. A loss of confidence in one of these markets can cause them to collapse, wiping out billions of dollars in a few days. Another risk arises from currency fluctuations. A strengthening in the Canadian dollar while you are invested abroad can eliminate any gains you might enjoy from the performance of the fund's investments.

If you are holding funds within a registered plan like an RRSP, the maximum foreign content is 30% of the cost of all the investments in the plan. To avoid that limitation, fund companies have created funds that invest most of their money in money market securities and use derivatives, such as forwards and futures on foreign stock indices, to get exposure to foreign markets. This lets these funds remain fully eligible for registered plans.

So-called "RRSP clone funds" will be another way to get around the 30% limit -- if Canada Customs and Revenue Agency gives its OK. They will let you, in effect, own an actively managed foreign fund, rather than an index. A fund company takes one of its existing foreign funds and creates a clone. This is done by using forward contracts that allow the clone to mimic the performance - good or bad - of the regular foreign fund. The forward contracts are with a Canadian bank, so these products are expected to count as Canadian content.

Based on preliminary information, it would appear the management expense ratio on these new funds might be about 0.50% more than the foreign fund they copy.

It probably doesn't make sense to hold a clone fund outside an RRSP, since the earnings from these funds are taxed the same as interest income - at your full tax rate. Earnings from the foreign fund would be taxed at a lower rate since those earnings would be counted as capital gains.

Another way to get foreign exposure is to buy equity funds that hold North American-based companies that have significant business in other countries.

Consider getting professional advice before investing your money.