UNDERSTANDING CLONE FUNDS

Question: How do clone funds work? Is it an option to allow greater foreign content within my registered retirement savings plan (RRSP)?

Answer: Clone funds are a risky investment because they use forward contracts with units of a foreign fund as its underlying asset. (Investors buy these contracts in Canada at a Canadian financial institution, which in turn, invests outside of Canada). The investment risk and return of the fund is tied to the value of the underlying foreign assets. Since the forward contract is the main holding of the fund, the fund is considered Canadian property.

One risk of owning a clone fund is that the forward contracts may not be renewed or negotiated. In this case the fund's return would be based on the holdings of the fund, which would include a small percentage of foreign securities and a large percentage of treasury bills. As a result, your overall return would tend to be lower than expected.

Outside of a RRSP, clone funds are not tax-effective because all income is distributed as interest income.

One of the main disadvantages of clone funds is they usually cost one half of a per cent or more on top of the underlying foreign fund management expense ratio. Many RRSP eligible clone funds now operate with management expense ratio's (MER's) of between three and four per cent. These added costs could quickly erode returns.

A second risk is these funds also have an amount of political risk since they flaunt the foreign content property limits set by the government. Pressure is now building on the government to close the loophole that allows clone funds to operate or eliminate or significantly raise the foreign property limit. Either action would limit or eliminate the need for clone funds altogether.

It's important to consider that foreign investments carry special risks such as: added volatility, the effect of Canadian currency on foreign returns, and foreign withholding taxes on registered returns.

These risks dictate that foreign investments should be added to your portfolio in a prudent and careful manner. I continue to stress that customers are well served through proper balance, diversification and the use of proper asset allocation processes.

Those who insist on greater exposure to foreign funds can do so by investing in segregated funds.

Segregated funds currently are not subject to the foreign content property limit that restricts foreign content to 30 per cent of the cost amount of a customer's registered portfolio. Customers can invest as much as 100 per cent of their portfolio in a foreign segregated fund until such time as the federal government introduces foreign content limits that apply to segregated funds.

A common strategy to increase foreign content is to invest 30 per cent in a pure foreign fund and 70 per cent in a domestic fund that invests up to 30 percent of its holdings in foreign investments. The resulting foreign content is 51 per cent (30 per cent of 70 per cent plus the additional 30 per cent).

Recent media attention has encouraged a return to Canadian investments. It's possible that the renewed interest and potential changes in foreign investment restrictions will combine to diminish the interest in foreign funds and RRSP-eligible clone funds.

This information is general in nature, and is intended for educational purposes only. For specific situations you should consult the appropriate legal, accounting or tax expert.