Before painting their portfolios red, white, and blue, Canadian income investors need to understand the drawbacks of playing the market from across borders, writes John Heinzl of Globe Investor.

O say can you see…all the great dividend stocks south of the border?

With about 78% of Canada’s benchmark index made up of just three sectors—financials, energy, and materials—many Canadians are looking to the United States to diversify their portfolios. It’s a prudent strategy, given the broad selection of US consumer, health care, and industrial stocks—sectors badly under-represented in Canada.

Many of these US companies are "dividend aristocrats," global powerhouses such as Procter & Gamble (PG), Johnson & Johnson (JNJ), McDonald’s (MCD), Coca-Cola (KO), and Wal-Mart (WMT) that have raised their dividends for at least 25 consecutive years. It’s like a big candy store for dividend lovers.

But before you start painting your portfolio red, white and blue, here are some things to watch out for.

A Taxing Dilemma

US stocks don’t qualify for the dividend tax credit, so if you hold them in a non-registered account, the taxman will take his full pound of flesh.

Specifically, you’ll pay a 15% US withholding tax on the dividend, and you’ll face Canadian tax on the full amount as well. You can usually use the initial 15% haircut as a foreign tax credit on your return, so the net result is that your US dividends will be taxed at the same rate as interest.

Using a tax-free savings account or registered education savings plan doesn’t solve the problem entirely, because you’ll still face the 15% withholding tax, which is not recoverable in these cases. (Under the Canada-US tax treaty, the 15% rate is reduced from the statutory non-treaty rate of 30%; your broker should fill out a W-8BEN form so you don’t get dinged at the higher rate.)

There’s a better option, however. Under the treaty, if you hold your US stocks in an account that provides pension or retirement income—a registered retirement savings plan, registered retirement income fund, or locked-in retirement account, for example—you won’t pay tax on your US dividends. That’s why many Canadians prefer to keep their US dividend stocks in an RRSP or RRIF.

To Hedge or Not to Hedge?

Even if you minimize your taxes, pick your stocks carefully, and hold through thick and thin, your gains could be wiped out if the currency market moves against you.

Case in point: For the ten years to October 31, the S&P 500 index rose 43.7%, including dividends. But a Canadian investor who bought the index without hedging his or her currency exposure would have suffered a 9.9% loss, all because of the loonie’s dramatic surge against the US greenback.

With the Canadian dollar now within spitting distance of parity, some investors say hedging isn’t nearly as important as it was when the loonie was trading for a mere 65 US cents back in 2001. Indeed, if the loonie were to slip from current levels, Canadians who don’t hedge their US exposure would be better off than those who do.

That said, the only way to know for sure you won’t get burned by the currency is to hedge your exposure. Sophisticated investors can accomplish this with currency futures and other products, but for retail investors the simplest option is to buy an exchange-traded fund with built-in currency hedging.

Examples include the iShares S&P 500 Index Fund CAD-Hedged (Toronto: XSP), Claymore S&P US Dividend Growers ETF (Toronto: CUD) and BMO Dow Jones Industrial Average Hedged to CAD Index ETF (Toronto: ZDJ).

Bear in mind that these ETFs won’t track their underlying indexes perfectly, because hedging isn’t an exact science, and also because there are costs involved (in addition to the fund’s management expense ratio).

For example, for the year to November 14, XSP posted a total return, including dividends, of 5.5%—a full percentage point less than the S&P 500 index return of 6.5%. Over long periods, even small differences like that can really add up.

NEXT: Currency Fees

Currency Fees

Brokers love clients who buy and sell US stocks and receive US dividends in registered accounts. That’s because, in addition to charging trading commissions, they collect a hefty currency conversion fee that can range from 0.5% to more than 1.5% on every transaction.

Until recently, if you held your US stocks in an RRSP, TFSA, or other registered account, you had no choice but to pay this fee every time you bought or sold a US stock or collected a US dividend, because the broker would automatically convert the currency back to Canadian dollars. The same goes for US-based ETFs.

But a growing number of online brokers—including RBC Direct Investing, BMO InvestorLine, Qtrade, Questrade, and Virtual Brokers—now give you the option to hold both Canadian and US dollars in a registered account, without forced conversion. This allows you, for example, to save up your US dividends until you’re ready to buy additional US shares or to convert currencies on your own schedule.

Ask your broker if it provides this service, whether there are any fees involved (some charge a $50 annual fee, others don’t) and which registered accounts qualify (many brokers don’t offer the dual-currency option for RESPs).

Investors who hold US stocks in a non-registered account have always had the ability to settle and receive dividends in US dollars, and thereby escape conversion fees altogether.

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