Should You Buy US-listed ETFs?

January 24, 2010

Jason, a reader of this blog, recently wrote to ask why an investor would want to invest in Canadian-listed  ETFs that hold US stocks when there are US versions with much lower fees.

For example, the iShares Canadian S&P 500 Index Fund (XSP) charges 0.24%, while the Vanguard Total Stock Market ETF (VTI) has an MER of just 0.09%. Jason had several specific questions—all very good ones—which I’ll attempt to answer.

Q: When one holds a US-based ETF, are the dividends paid out in US dollars and then converted to Canadian dollars by the brokerage, costing the investor conversion fees?

Yes, dividends earned from US-listed ETFs are paid in US dollars. If you hold the ETF in a taxable account, the dividends simply go onto the US-dollar side of the account. But if you hold the ETF in RRSP or other account that does not allow US dollar holdings, your broker automatically converts them before depositing them in your account. This usually incurs a fee of about 1% or more: check your broker’s website or call and ask.

While this conversion fee does cause a small drag on your dividend return, keep it in perspective. Broad-based ETFs of US stocks currently pay dividends of around 2% annually, and a 1% currency conversion fee would reduce your yield to 1.98%.

The bigger impact of foreign exchange fee comes during the purchase and sale of US-listed securities. Let’s say a Vanguard ETF is trading at $50 US per share and the loonie is currently worth 95 US cents. A straight conversion works out $52.93 Canadian, but a 1% conversion makes your price $53.46. You’ll lose another 1% when you sell the shares.

The trading commission on US securities is typically higher as well.

Q: Is this why some brokerages now offer RRSP accounts that can hold US dollars?

Currently only two discount brokerages—Questrade and QTrade—allow Canadian investors to hold US dollars inside registered accounts, which allows you to receive dividends in US dollars and sidestep the conversion fees. [Update: RBC Direct Investing, BMO InvestorLine and Virtual Brokers all offer this service now.]

Questrade offers the service for free, but QTrade charges $50 annually. Paying that fee makes sense only if you do a lot of trading, or if you have significant US holdings.

Q: Would it be better to hold XSP if you have a Canadian dollar account, because you would not have these conversion fees?

It is true that buying and selling XSP is cheaper than trading US-listed ETFs for the reasons explained above.

In theory, at least, the dividends should be higher, too. XSP simply holds the US version of the iShares S&P 500 Index Fund (IVV), which means that XSP receives dividends from IVV and then converts them to Canadians dollars before distributing them. An iShares spokesperson I asked about this explained that XSP is able to convert currencies at the institutional rate, which means “there is almost no spread at all.” This, he explained, should allow investors to collect dividends at full value and avoid being charged a conversion fee by the broker.

Q: In a TFSA, would both the Canadian- and US-listed ETFs have foreign withholding tax taken off?

Yes, but in different ways.

Many countries, including the US, withhold taxes from dividends paid to foreign investors. For example, if you’re a Canadian holding a US-listed ETF in a taxable account, Uncle Sam deducts 15% of your dividends before you receive them. (You can typically claim the foreign tax credit tax when you file your return.)

The good news is that Canada and the US have a tax treaty that allows investors to avoid this tax if they hold their US investments in an RRSP or RRIF. However, that treaty does not apply to Tax-Free Savings Accounts or RESPs, so if you hold a US-listed ETF in one of these accounts you will indeed be subject to the withholding tax.

Now, here’s where it gets confusing. When a Canadian-listed ETF holds a US-listed ETF (such as XSP, which simply holds IVV), it too is subject to the withholding tax. The dividends are taxed at 15% before they are paid to the Canadian ETF sponsor, and then these reduced dividends are passed on to investors. So if you hold XSP in your Tax-Free Savings Account, you’re still getting dinged with the withholding tax: it just happens indirectly.

In fact, even If you hold XSP in your RRSP, you’ll see your dividends shrink by the amount of the withholding tax. Because the fund itself is being taxed here, not the individual who holds shares of the fund, the tax treaty doesn’t apply. This is an important consideration that even many advisors are clueless about. Canadian Capitalist wrote an excellent post on the topic last year.

Q: So what’s the bottom line?

For the long-term investor who wants to hold US stocks, and who is not concerned about currency risk, it is usually better to buy US-listed ETFs than their counterparts that trade on the TSX.

While currency conversion fees are not trivial, they are usually more than offset by the lower MERs and (in RRSPs) the preferential tax treatment. That is why most of the Model Portfolios on this site recommend Vanguard ETFs for US and international equities.

Canadian investors who worry about the loonie appreciating in value may be willing to pay more for XSP or other ETFs that use hedging strategies to smooth out currency fluctuations. But that’s a whole other discussion that will have to wait for a future post!

Thanks for the great questions, Jason.

{ 18 comments… read them below or add one }

Doctor Stock January 24, 2010 at 8:54 pm

Great responses… at the end of the day, I think most investors can create their own ETFs and pay themselves. The major exception would be in the bond market.

Canadian Couch Potato January 24, 2010 at 10:08 pm

Doctor: Can you explain what you mean by creating their own ETFs? Do you mean by buying individual stocks?

Jason January 25, 2010 at 10:29 am

Thank you very much for taking the time to answer my questions! You have explained things very well and this has cleared up a lot for me.

Canadian Capitalist January 25, 2010 at 11:56 am

Thanks for the mention. One disadvantage of US-listed ETFs is US Estate Tax rules. Since, US-listed ETFs are considered as US property, it might become an issue even for Canadian citizens and residents. To make things even more confusing, US Estate Tax laws change all the time.

If an investor wants to avoid the foreign exchange hit when selling and buying US-listed ETFs, they might want to check out discount brokers who offer what’s called “wash trading”. TD Waterhouse, for instance, automatically sets the same buy and sell exchange rates on US stocks or ETFs sold and purchased on the same day.

Pacific January 25, 2010 at 12:39 pm

It would be easier for me to understand this confusing and complicated issue if you were just a little more specific in some areas.
Here is an example:
your sentence:
“Paying that fee makes sense only if you do a lot of trading, or if you have significant US holdings.”
It would be good if you gave some indication of “significant” in that sentence, for example, — are we talking in the $25,000 range or in the $250,000 range or over 2 million???…

Other than that peeve, thanks for trying to make some sense out of these confusing rules!

Canadian Couch Potato January 25, 2010 at 1:08 pm

Fair comment. But it’s often hard to be specific because so many factors affect these decisions.

In the case of the $50 QTrade fee, think of it like this: if a store charged $50 for a membership that gives you a 10% discount on merchandise, it would only be worth it if you spent more than $500 a year at that store (because your 10% discount would save you more than $50).

With QTrade, assuming you lose 1% of your dividends to foreign exchange fees, then you’d need to receive more than $5,000 in US dividends to make it worthwhile to pay a $50 fee. And to get $5,000 in annual dividends, you would need about $250,000 in US holdings. (US stocks on average yield about 2% these days.)

Holding US dollars in your account might also save you about $1 or so on trading commissions when buying and selling US stocks or ETFs. So again, unless you make a lot of trades, you’re wasting your money on the $50 upfront fee.

If you plan to buy or sell a US-listed ETF, you can do the math here, too. If you buy $10,000 worth of shares, the 1% fee would save you $100, so the $50 fee seems worthwhile. But if you’re going to hold that ETF for 10 years, is it worth it paying that $50 annually? Probably not.

Hope that makes some sense.

MadMatt January 25, 2010 at 2:50 pm

Ok, you convinced me. I’m moving my overpriced Fidelity Funds over to ETF’s but I have a couple of questions that are most likely already been asked but here goes.
I have my RRSP approx. $60,000, my wife’s – $60,000, a spousal for her – $15,000, and a RESP for the little ones (6 and 3) at $20,000.
Are the spousal and RESP too small to move over or should the mix of ETF’s (looking at the model portfolio’s) be scaled down?
Secondly, we have always been monthly contributors, should we stick that way with Claymore’s option or is once a year re-allocation just as effective. I have no problem taking that monthly contribution and putting it into a money market fund and using it once a year for a larger investment. What advantage if any is there to dollar cost averaging?

Canadian Couch Potato January 25, 2010 at 3:29 pm

Hi Matt: The spousal RRSP and RESPs are definitely to small too bother with ETFs. I’d suggest using index funds for these. $60K is enough to build a portfolio with ETFs, so long as you don’t make it too complex (five or six ETFs is plenty).

As a regular monthly contributor, you could always use both ETFs and index mutual funds in your RRSPs. For example, use ETFs for your equity holdings and an index fund for your bonds. Make your monthly contributions to the bond fund and then add to the ETFs once a year or so, if necessary. Dollar cost averaging is a good strategy, but not as important as regular saving.

Good luck with your investing!

Doctor Stock January 29, 2010 at 9:26 pm

Yes, essentially. I find it is possible to find representative stocks that provide balance and diversity within a sector. This substitute to ETFs has been extremely successful for me, allowing me to pay myself and keep greater control of my investment decisions.

Mike February 11, 2010 at 12:57 am

I love this site! Please keep it up.

I’m considering opening a Questrade RSP account where I would like to hold Vanguard ETFs. I only plan on making trades a couple times a year to keep things balanced and I don’t plan on holding anymore than 4-5 ETFs. Is there any reason not to take advantage of Questrade’s option to hold and trade in USD? I understand it will cost me $5 each day I trade in USD, plus $20-$25 dollars for the 4-5 trades I’m planning on making twice a year, but I will save on the 0.5% currency conversion. As far as I can figure it, the USD account makes sense.

Any advice? Am I missing anything?

Thanks so much.

Canadian Couch Potato February 11, 2010 at 1:29 am

Mike: Thanks for the kind words. I don’t have a Questrade account, so I can’t speak from personal experience. But the ability to hold USD inside an RRSP is indeed an advantage when trading US-listed ETFs and when you receive dividends from those funds. And since the service is free at Questrade, I can’t see any downside. (Obviously, you should try to do all your US trades in the same day to avoid paying that $5 more than once.)

If other readers of the blog have any insights to share, please speak up!

DanielC February 21, 2011 at 11:02 am

Pardon the newbie question. With the Can-US exchange rate so favorable right now, is this the ideal timing to buy US ETF’s such as those from Vanguard? I dont have a crystal ball, but I assume that the Can dollar can do one of two things, which is stay at PAR, or go back down at one point.

Im contemplating signing up for discount brokerage, to buy and hold (couch potato) Vanguard Index ETF’s. My goal is to first open personal RRSP and LIRA accounts, and then spousal RRSP account. Then I want to move my existing Altamira Index Mutul Funds with MER of .63%, to various iShares and Vanguard ETF’s. My largest chunk of RRSP’s and LIRA’s are at National Bank, which is where I have my banking (mortage, HELOC, etc). Due to the “size” of my $155,000 portfolio, signing up for their National Bank NBDB discount brokerage would lower trade fees to $9.95 + currency conversion. Even if this is probably higner than most non-bank based brokerage firms, the impact to me is not so great since I would not be trading often, (yearly contribution and/or re-balancing my portfolio).

Even if there are lower MER Canadian Funds out there such TD e-Series, I think moving to another big-bank brokerage is pointless, since going forward, I would rarely contribute into these mutual funds anymore, if at all. As it stands now, it is more advantageous for me to contribute to my employer matching RRSP program, and “pay myself” directly from my gross pay. The once a year, move this amount to my ETF’s.

Does my strategy make sense?

Wasyl October 31, 2013 at 4:49 pm

Hi CCP,

I have a 7-figure investment portfolio distributed in TD Waterhouse (Regular, RRSP, USD accounts), an RPP and ESPP. I recently subscribed to MoneySense and plan to now become a CP myself using the Complete Couch Potato model portfolio (CCPMP) . I have several questions.

1) Why doesn’t the CCPMP always use the lowest cost recommended ETF in the category? (ex. why ZCN and not HXT?)

2) What $ amount in US investments can lead to additional paperwork or potential issues with the CRA and the IRS? I would plan to maximize my USD ETF holdings given the lower MERs.

3) Related to my question #2, what are risks and benefits of using VTI vs VUN? Do they provide the same return?

4) What is Norbert’s Gambit?

Thank you.

Canadian Couch Potato October 31, 2013 at 5:10 pm

@Wasyl:

1. HXT is a specialized ETF with some additional risks:
http://canadiancouchpotato.com/2011/06/06/understanding-swap-based-etfs/
http://canadiancouchpotato.com/2011/06/08/swap-based-etfs-what-are-the-risks/

2. US Estate taxes are complex and have changed recently. Definitely consult a specialist if you think they may apply.
http://canadiancouchpotato.com/wp-admin/edit-comments.php?p=465&approved=1

3. Their returns will be very similar. VTI has a lower management fee and is exempt from US withholding taxes on dividends if held in an RRSP. VUN trades in Canadian dollars, which is likely to result in much cheaper transaction costs.

4. Norbert’s gambit is a method for converting Canadian and US dollars. Here’s an introduction. There’s lots of information online: be aware it works a little differently at each brokerage.
http://www.moneysense.ca/invest/norberts-gambit-a-better-way-to-buy-u-s-dollars

James January 26, 2014 at 11:25 pm

http://www.theglobeandmail.com/globe-investor/funds-and-etfs/etfs/us-etfs-top-picks-for-canadian-investors/article6115956/

Thank for the effort of explanation. I also read the article published in the above address. You made me a little bit clear now but far from making decision confidently.

I have Vanguard S$P 500 VFV in my RRSP account as the US component. After knowing that the taxed dividend will be not recoverable, I had intention to open a US account. As I read more posts, It seems still too complicated and have a sense (only a sense) that holding VFV may least bad option.

My VFV has a volume about 40,000 now and 2-3 transactions (purchasing) a year for contibution/rebalance.

What is your comments? If I need to have a US dollar account, I have to switch from TDWH.

Thanks

Canadian Couch Potato January 27, 2014 at 11:20 am

@James: I urge you to consider the big picture. Foreign withholding taxes are just one or many factors to consider. I can’t imagine it makes sense to switch brokerages or dramatically change your strategy to avoid this relatively small drag (about 0.3%) on one part of your portfolio. Keep it simple.

PaNdEm1K April 8, 2014 at 12:28 pm

@CCP excellent ETF discussion(s) on your site. On that note, in your model portfolio’s it is suggested that one should not invest in the ETF based options unless a minimum suggested value of $50,000 is attained to start/buy-in. What would be the difference behind starting fresh (lets say $10,000 buy-in) of TD e series(or any other) mutual fund portfolio vs an ETF portfolio? Thanks for your time again!

Canadian Couch Potato April 8, 2014 at 12:41 pm

@PaNdEm1K: Pleas see this blog post for a discussion of this idea:
http://canadiancouchpotato.com/2012/07/30/comparing-the-costs-of-index-funds-and-etfs/

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