Will the Real S&P 500 Please Stand Up?

I received an email recently from Scott, a reader with a great question about index funds and ETFs that track the S&P 500. He agreed to let me share his letter and my response.

“I’ve been using index funds for some time now, but have been giving ETFs more thought. Specifically, I’m interested in switching my TD U.S. Index Fund (e-Series) to a U.S.-listed ETF such as the SPDR S&P 500 (SPY). Before I proceed though, I’d like to know why the TD fund has lagged behind SPY in terms of return? I was told in a forum that it may be due to the currency in which I am purchasing the funds. TD e-Series funds require me to use Canadian dollars. However, buying SPY would require me to use U.S. dollars. Do you have any insight about why there is much of a difference between the two?”

First, it’s important to note that there are actually three e-Series funds that track the S&P 500, and they all have very different characteristics:

  • Scott owns the TD U.S. Index (TDB902) fund, which is bought and sold in Canadian dollars, but does not use currency hedging. This means that the fund’s value will go up and down with fluctuations in the exchange rate. In a year where the S&P 500 returns 10% in U.S. dollars, but the greenback falls 2% against the loonie, the fund’s return for a Canadian investor like Scott will be only 8%. If the greenback gains 2% against the loonie, Scott would enjoy a 12% return. (In fact, the math isn’t quite so tidy: see this post for more detail.)
  • The TD U.S. Index Currency Neutral (TDB904) fund is also bought and sold in Canadian dollars, but the fund uses hedging to smooth out the effect of currency fluctuations. If the S&P 500 returns 10% in U.S. dollars, a Canadian investor should also expect a 10% return. (In practice, hedging is not precise, so it’s common for currency-neutral funds to return a bit more or a bit less than the benchmark in any given year.)
  • Finally, the TD U.S. Index $U.S. (TDB952) is bought and sold in U.S. dollars. Scott wasn’t quite right to say that Canadians can only buy mutual funds in Canadian dollars. It’s true that most brokerages, including TD Waterhouse, do not allow you to hold U.S. dollars in an RRSP. But it’s common to do so in taxable accounts. As long as this fund is held on the U.S. side of the investor’s account, it will be completely unaffected by currency fluctuations.

To give you an idea of how these three funds behave differently, here are their returns over the last nine years, compared with the S&P 500 Total Return Index (that is, including dividends):

TD U.S. Index ($CAD) TD Currency  Neutral ($CAD) TD U.S. Index ($USD) S&P 500 ($USD)
2001 -6.7 -13.4 -12.4 -11.9
2002 -23.2 -22.7 -22.4 -22.1
2003 4.3 30.0 27.9 28.7
2004 2.2 11.1 10.2 10.9
2005 1.7 3.3 4.3 4.9
2006 14.7 14.0 15.1 15.8
2007 -11.1 3.1 4.9 5.5
2008 -21.7 -39.0 -37.4 -37.0
2009 6.7 22.2 25.7 26.5

OK, let’s get back to Scott’s original question: why has his TD U.S. Index fund performed so much differently from SPY? The reason is that SPY’s returns are expressed in U.S. dollars: if Scott had held SPY in a Canadian-dollar account, its performance would have been very similar to what he’s getting in his TD fund. Had he invested in the currency-neutral version of the TD fund, however, he would have enjoyed returns closer to what SPY delivered to U.S. investors.

The currency-neutral fund performed better over the last 10 years because the Canadian dollar has been strong by historical standards. There’s no reason to expect that to continue in the future, however: in theory, at least, currency fluctuations should even out over the very long term. But as you can see from the table, the short-term differences can be large.

The bottom line for Scott is that swapping his TD U.S. Index Fund for SPY won’t make a big difference if his account is in Canadian dollars. True, SPY has a much lower annual fee (just 0.09% compared with the index fund’s 0.33%), but the ETF will cost him a brokerage commission and currency exchange fees every time he buys and sells. In most cases, he would be better off sticking with the TD fund.

 

22 Responses to Will the Real S&P 500 Please Stand Up?

  1. Strange_Machine August 11, 2010 at 8:54 am #

    What TD US index fund should we be holding in our e-series portfolio then? TD US Index in CDN or US Dollars? I’m currently holding TD US Index e** CDN. Should I switch to the US dollars one? Btw, on the online interface they never show the codes for the fund, is there a way to show that? ie) TDB902… When I buy things it just shows the name value.

  2. Canadian Couch Potato August 11, 2010 at 9:27 am #

    @Strange Machine: There’s no right or wrong answer to your question. You should hold whichever fund suits your investment goals. The important idea is that you should understand what you’re holding and how it can be expected to perform when the currencies fluctuate.

    RE: getting the fund numbers to show up, sorry, I’m not familiar enough with TD WebBroker to help. I’d suggest giving them a call.

  3. Slacker August 11, 2010 at 1:34 pm #

    Holding TDB902 ($CDN) vs TDB952 ($US) is equivalent. Once everything is converted back to Canadian dollar, it should have the same performance. Both TDB902 ($CDN) and TDB952($US) exposes you to currency fluctuations. The TDB952 ($US) is just a convenience for you in case you have some $US around.

    The choice is between TDB902 ($CDN) and TDB904(hedged). One provides exposure to CDNUS currency fluctuation, the other attempts to hedge the risk. The hedged version has a higher MER of 0.48%, instead of 0.33%. Also note that hedging probably has additional cost not counted in the MER, and it doesn’t work perfectly, so expect greater variability with the hedged version.

    The “fund code” can be found in the fund’s page:

    https://www.tdassetmanagement.com/Content/Products/MutualFunds/Funds/p_FundCard.asp?FID=3269&PID=10&SI=5
    https://www.tdassetmanagement.com/Content/Products/MutualFunds/Funds/p_FundCard.asp?FID=3270&PID=10&SI=5

  4. Slacker August 11, 2010 at 1:41 pm #

    Speaking of which, an article from Canadian Business provides a rationale on when to hedge and when not to hedge.

    http://blog.canadianbusiness.com/ppps-a-tool-for-foreign-diversification/

  5. Andrew Hallam August 17, 2010 at 6:00 am #

    Nice article—and Slacker, nice work with your comment.

    Over the long run, I don’t think hedging will be beneficial at all. Trying to time currencies isn’t likely to work, and over the long haul, it should be a wash anyway. Also, Slacker is right about the higher MER and the higher operational expenses due to the hedging. And the extra cost, in my opinion, isn’t going to be worth it, long term.

  6. Why August 29, 2010 at 2:32 pm #

    Strange Machine: You say you own tdb902, so using WebBroker and looking at your account’s holdings, you will see the fund number displayed in a small window after you place your cursor over the name of the fund and wait for a second or so.

  7. Why August 29, 2010 at 2:53 pm #

    CCP wrote above: “It’s true that most brokerages, including TD Waterhouse, do not allow you to hold U.S. dollars in an RRSP.”

    As an update you will be pleased to know that TD Waterhouse is permitting to have a US$ money market fund, TDB166, inside an RRSP. They also allow “wash trades” in US$, i.e. clients pay in US$, using the US$ money market fund. For ETF and other trades the commission is in US$, but only US$9.99 if you have at least CAD $100k invested with TD Waterhouse. Not certain if this works for investing in mutual funds or just for trades such as ETF purchases.

    By the way trades are CAD$9.99 for Canadian $ ETFs, and for all other trades in Canadian dollars, if you trade online and maintain at least $100k with TD Waterhouse. I believe it’s the same with BMO and some other big online brokers, as reported by Rob Carrick in his annual review.

  8. The Dividend Ninja January 22, 2011 at 12:53 pm #

    Hi Dan,

    So I am setting up the US Asset Allocation for my couch potato (ninja style) portfolio. I’m with TD so I can use their e-series funds. From what I am reading it would be better to purchase the TD US Index ($CAN) than the TD US Index Currency Neutral. As Andrew points out in his post, the extra hedging cost does not seem worhtwhile, and I have noticed from the TD Site that the difference of hedgin is about -2% per year in annual returns.

    Will the diffrence in the exchange rate between the US and Canadian Dollar, only affect the return on the TD US Index ($US) fund, but not affect the TD US Index ($CAN) fund? Is my logic correct here ?

    Thanks Dan!! 🙂

  9. Canadian Couch Potato January 22, 2011 at 7:54 pm #

    @Ninja: Yes, you’re correct. The currency neutral one is the only one that is not affected by the exchange rate. The other two should perform similarly in CAD terms. Remember that TDB952 is bought and sold in US dollars.

  10. The Dividend Ninja January 24, 2011 at 1:50 am #

    Thanks Dan! So the TD US Index ($CAN) is the better choice over TD US Index Currency Neutral?

  11. Canadian Couch Potato January 24, 2011 at 8:34 am #

    @Ninja: It’s not really about better or worse: some people do really want currency hedging, and that’s fine. But in my opinion, for investors who are in for the long term and willing to admit they have no idea where the dollar is headed, the unhedged (CAN$) version makes more sense.

  12. Ben March 14, 2011 at 1:41 am #

    With the TD Index ($CAD), are the dividends paid in $US or $CAD? And are they paid annually?

  13. Canadian Couch Potato March 14, 2011 at 2:19 am #

    @Ben: The companies pay the dividends in USD, of course, but they are converted to CAD before showing up in the fund. In a mutual fund, the dividends are typically reinvested whenever they are received rather than being paid in cash.

  14. CJOttawa May 10, 2012 at 1:40 pm #

    The article link “Slacker” posted above is broken but the article is now available here: http://www.canadianbusiness.com/blog/investing/18322–ppps-a-tool-for-foreign-diversification

    Great post and still very relevant. Thanks.

  15. Luc April 9, 2015 at 3:17 pm #

    @CCP

    Hello. I know this is a somewhat old topic, but it still seems relevant. Just wanted to follow on from Ben’s question above. Regarding the “TD US Index – e”, and the “TD US Index – e (US$)”, why would dividends be converted back to CAD before showing up in the fund? My understanding is that for the CAD fund, you buy in CAD, CAD is converted to USD (at the current xrate spread), and the underlying securities are purchased by TD in USD. The advantage of the USD denominated fund, is that if you have a bunch of USD in cash or another USD denominated account, you can forego the currency spread by buying into the USD denominated fund directly.

    Perhaps I’m misunderstanding. I’m trying to understand which fund is more efficient in terms of the reinvestment of distributions, the CAD denominated fund, or the USD denominated fund? If USD dividends are going to be subject to xrate spread to convert them back to CAD, (and then back into USD to be reinvested??), then it seems like the USD denominated fund is more efficient, even if you have to stomach the initial conversion spread from CAD to USD when you buy the first time.

    Maybe this has been settled before, so I apologize if I’m bringing up a dead issue. The TD website and forums talk a lot about “Wash trades” where the dividend can be washed through a USD Money Market account etc, but that seems like an inconvenient and unnecessary complexity to me.

    I’m not interested in currency hedging, just wondering about the CAD vs USD denominated accounts.

    Thanks.

  16. Canadian Couch Potato April 9, 2015 at 3:29 pm #

    @Luc: If you hold the USD-denominated version at TD Direct, it should sit on the USD side of the account, so any dividends paid in cash should be paid in USD and will stay in USD. There would be no conversion to CAD and then back to USD. (In fact, I imagine most investors would elect to have the dividends reinvested in the fund automatically and never paid out in cash.)

    There should be no difference between these funds in terms of which “is more efficient in terms of the reinvestment of distributions.” I would certainly not use the USD version if that’s your prime concern, The only reason to use the USD version is that you currently hold USD cash that you do not want to convert to CAD,

  17. Luc April 9, 2015 at 4:53 pm #

    @CCP: Great, thanks for clarifying. I guess it was this statement that had me confused about the dividends being converted to CAD:

    ” Canadian Couch Potato March 14, 2011 at 2:19 am #

    @Ben: The companies pay the dividends in USD, of course, but they are converted to CAD before showing up in the fund. In a mutual fund, the dividends are typically reinvested whenever they are received rather than being paid in cash.”

    I’ll continue to invest USD in the USD fund, and CAD in the CAD fund, but from what I understand, it’s all ending up in the same place. Indeed, if you click the “Fund Facts” for the CAD version or the US$ version, you get the same PDF.

  18. Deb April 26, 2015 at 8:32 pm #

    @CCP: So I’m hearing that in the long run, the unhedged CAN$ (TDB902) makes more sense. When I look at the actual holdings, TDB902 shows holdings in specific companies such as Apple, Exxon, Microsoft, etc. whereas the hedged version (TDB904) shows holdings in TD US Index – I and S&P 500 Index. Does this make a difference when deciding which TD US Index – e to choose?

    The same question goes for the International Indexes: TDB905 and TDB911. The former shows holdings in TD International Index – I and MSCI EAFE Index Future. The latter shows holdings in iShares MSCI EAFE, Nestle, Novartis, etc. Which TD International Index – e would be the “better” choice?

  19. Canadian Couch Potato April 27, 2015 at 12:08 am #

    @Deb: The market exposure in hedged an unhedged funds is exactly the same. Both versions of an s&P 500 index fund have the same exposure to the 500 companies in the index. However, some index funds do not hold the underlying stocks directly: rather, they use index futures (a type of derivative) to get their exposure. And a few will hold a ETF tracking the same index. My preference is always to stick with the most plain vanilla version, with the stocks held directly and no currency hedging.

    http://canadiancouchpotato.com/2011/07/12/whats-in-your-index-fund/
    http://canadiancouchpotato.com/2011/07/14/why-do-index-funds-use-derivatives/

  20. suneet January 2, 2016 at 8:55 pm #

    Hi
    There is another TD index fund – TDB217 that tracks the S&P. Just curious, why this was not included in the initial write-up? Is this fund not available to retail investors?
    Regards,
    Suneet

  21. Canadian Couch Potato January 2, 2016 at 10:05 pm #

    @suneet: TDB217 is traded in USD and is not an e-Series fund. Its performance would be very similar to SPY, albeit with higher cost.

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