Invest Overseas with Ease: Understanding ETFs and CDRs

By Zayla Saunders, Sr Associate, Online Distribution, BMO ETFs

Looking to build a diversified portfolio with your favourite stock selections? Many exchange-traded funds (ETFs) can provide you with broad market exposure, while Canadian depositary receipts (CDRs) let you target ownership of specific global stocks - all in Canadian dollars.

By blending these two options, investors can achieve an ideal mix of broad market exposure and precise stock choices. In this article, we dive into how ETFs and CDRs can complement each other to enhance your portfolio strategy.

Summary:

●     Diversification and precision – Many ETFs provide broad market exposure, while CDRs allow for high-conviction in individual global companies.

●     No FX hassle – CDRs allow you invest in foreign companies in Canadian dollars.

●     Retain key benefits – CDRs provide fractional pricing, dividends, and voting rights – similar to owning the underlying foreign company’s stock.

Best of Both Worlds

Investors often face a trade-off between broad diversification and high-conviction stock selection. Many ETFs provide diversified exposure to entire markets, while CDRs allow for targeted investments in individual global companies. By strategically combining certain ETFs and CDRs, investors can refine their portfolios to align with both long-term market trends and specific investment opportunities.

What is a CDR?

CDR stands for Canadian depositary receipt. A CDR represents fractional ownership of a foreign stock, but instead of purchasing shares in a different currency, investors can buy them in Canadian dollars directly through their online self-directed brokerage account or through their financial advisor.

CDRs aim to simplify global investing for Canadians by eliminating the need to navigate foreign exchanges and manage currency fluctuations themselves.

Understanding How CDRs Work

Investing in global companies often comes with the challenge of foreign currency exposure and additional trading complexities. That’s where CDRs come in.

A depositary bank like Bank of Montreal (BMO) issues CDRs that are linked to shares of foreign companies to Canadian investors, allowing them to access global markets without setting up foreign brokerage accounts or handling currency conversions.

By holding CDRs, investors are entitled to receive dividends, if any, and retain voting rights proportional to the number of underlying foreign shares to which they are entitled to. They also benefit from fractional pricing, which makes high-priced global stocks more accessible.

Built-in Currency Hedging: Reducing FX Risk

One of the unique advantages of CDRs is built-in currency hedging. Currency fluctuations can impact investment returns, but CDRs automatically adjust for exchange rate movements, helping to smooth out volatility.

For example, if an investor holds a foreign stock directly and the Canadian dollar weakens, their investment's value in CAD terms would increase. But if the CAD strengthens, their returns could be negatively affected. CDRs mitigate this uncertainty by incorporating a hedging mechanism, allowing investors to focus on a stock’s fundamentals.

How ETFs and CDRs can Complement Each Other

Many ETFs serve as the foundation of a well-structured portfolio for investors, offering broad diversification and liquidity. For those looking to fine-tune their exposure, integrating CDRs into their portfolio offers a currency-hedged tool to selectively increase allocations to specific companies based on conviction and market views.

However, as with any investment product, investors should conduct thorough due diligence on the underlying foreign company before investing in a CDR. Here are several use cases:

Boosting Sector Weights via Stock Tilts

An investor holding a global equity ETF like the BMO MSCI All Country World High Quality Index ETF (TSX:ZGQ)¹ as a core allocation can use CDRs as a way to boost weightings to relatively underrepresented sectors by adding reputable names.

Example: Adding BMO’s CDR linked to Swiss bank UBS (UBS CDR (CAD HEDGED) to increase financial weights or consumer staples giant Nestlé (NESTLE CDR (CAD HEDGED) for greater emphasis on defensive stocks.

Expanding Global Exposure Beyond the U.S.

An investor using the BMO Nasdaq 100 Equity Index ETF (TSX: ZNQ)² for their core technology allocation may want to broaden their technology exposure beyond the U.S.

Example: Adding BMO’s CDR linked to Japanese video game icon Nintendo (NINTENDO CDR (CAD HEDGED)

Opportunistic Stock-Specific Investments

Investors who use ETFs for their core portfolio and direct stocks for their satellite positions can leverage BMO’s CDRs to increase exposure to high-conviction stocks when market opportunities present themselves.

Unlike ETFs, which provide only partial exposure, CDRs allow investors to invest directly in a specific foreign company while avoiding the complexities of foreign currency transactions. This makes CDRs particularly useful for investors looking to selectively boost exposure to their best ideas while managing currency risk.

Managing Currency Risk

For investors wary of currency fluctuations - CDRs provide exposure to international stocks while automatically hedging back to CAD. This helps mitigate the foreign currency risks associated with a strengthening CAD, though investors won’t capture currency-driven gains if the loonie declines.

Illustrative Example: How Maya Blends CDRs With ETFs to Invest in Her Convictions

Maya is a Canadian investor focused on building long-term wealth. She has a core exposure to domestic and U.S. markets through the BMO S&P/TSX Capped Composite Index ETF (ZCN)³ and BMO S&P 500 Hedged to CAD Index ETF (ZUE)⁴ as she prefers keeping her investments in CAD.

While both of these ETFs provide broad market exposure, Maya has strong convictions in specific global companies, particularly in healthcare and technology. Rather than overhauling her portfolio or dealing with foreign exchange complexities, she strategically integrates CDRs to fine-tune her exposure.

How Maya Executes Her Strategy

Step 1: Identifying High Conviction Stocks

After researching industry trends, Maya identifies Novo Nordisk as a compelling opportunity, given the growing demand for diabetes and obesity treatments. She also sees ASML as a key beneficiary of the AI-driven surge in computing demand.

Step 2: Using CDRs for Targeted Exposure

Rather than adjusting her ETF holdings, Maya purchases BMO’s CDRs linked to Novo Nordisk and ASML, allowing her to gain direct exposure to these companies in CAD while benefiting from built-in currency hedging and fractional pricing.

Step 3: Reaping the Benefits (And Not the Headaches)

Maya now enjoys the best of both worlds - broad diversification through her selected ETFs and targeted exposure through her CDRs. She collects dividends in CAD, avoids FX complexities, and gains confidence in her portfolio’s resilience and precision.

By strategically combining these ETFs and CDRs, Maya balances broad market exposure with high-conviction investments, creating a smarter, more customized investment strategy.

What Are the Differences Between CDRs and ETFs?

While CDRs and ETFs come with their own features and benefits, the distinctions between them are noteworthy.