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):

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.

Thank you to the dozens of readers who commented on my post about how TD makes it unnecessarily difficult to buy its e-Series funds. Congratulations to Al, who won the draw and will receive a copy of Gordon Pape’s The Ultimate TFSA Guide.