Inside the New Vanguard ETFs

August 16, 2013

Vanguard Canada launched some new ETFs this week, and I spoke with managing director Atul Tiwari about the funds. Let’s take a closer look.

Cross-Canada coverage

The Vanguard FTSE Canada All Cap (VCN) expands on the older Vanguard FTSE Canada (VCE). While VCE holds 78 large-cap stocks, the new index includes 255 holdings and covers 96% of the Canadian equity market. That makes it roughly equivalent to the S&P/TSX Composite Index, which holds 234 companies and claims 95% coverage.

This is about as close as you can get to a total-market index in Canada: dig further and you run into serious liquidity problems with small, thinly traded stocks. “We started out with a very large universe and pared it back to a number we thought would be terrific,” Tiwari explains. “But once you get to the practical aspects it gets pretty tough. Our partners on the capital markets side, who are creating units and doing the market making, have to be comfortable they can find these securities. Obviously there’s a cost associated with that, and at some point it gets too unwieldy and it doesn’t make sense.”

With a management fee of just 0.12% (the MER will be a few basis points higher), VCN is now the cheapest broad-market Canadian equity index fund available.

USA all the way

The most significant of the new ETFs is the Vanguard U.S. Total Market (VUN), a long-awaited Canadian version of the Vanguard Total Stock Market (VTI), which holds about 3,500 stocks and blankets 99% of the US equity market. Vanguard’s initial launch in 2011 included a version of this fund with currency hedging (VUS), but this new ETF is not hedged to Canadian dollars.

VTI is a core holding in my Complete Couch Potato portfolio, but VUN may be a better alternative for most Canadians. While VTI’s annual fee is just 0.05% (compared with 0.17% for the two Canadian versions) it must be bought and sold in US dollars, which adds a significant cost. Even if you use Norbert’s gambit, you should expect to pay at least 0.20% to convert loonies to greenbacks, and if you’re accepting your brokerage’s normal foreign exchange rates—as many investors do—that cost can easily be 1.5% each way, which wipes out any advantage for VTI.

There are a couple of other factors to consider when deciding between VTI and VUN. The US-listed version is more tax-efficient in an RRSP, because it is not subject to withholding taxes: these would cause a drag of about 0.30% (based on a 2% yield). On the other hand, the Canadian-listed version is not vulnerable to US estate taxes, which may a boon for wealthy Canadians.

Smaller investors will also appreciate that Vanguard has set the unit price for VUN around $24, which makes it easier to buy small amounts and use DRIPs. (After the run-up in US markets, VTI now trades at a lofty $86 a share.)

Over the hedge

Also new on the menu is the Vanguard FTSE Developed ex North America (VDU), an unhedged version of Vanguard’s existing international equity fund (VEF).

Not long ago, index investors were asking why it was so hard to find an international equity ETF without currency hedging, but iShares changed that in April with launch of the iShares MSCI EAFE IMI (XEF). In doing so, they scooped Vanguard. “We definitely would have been out earlier with these unhedged products: we had them in our product plan from the start,” Tiwari says. “But we couldn’t actually come out with them because we knew we were transitioning out of the MSCI indexes. It wouldn’t have been right to launch them and then very quickly make the change in indexes. ”

Vanguard has also dropped the management fee on two existing ETFs. The cost of VEF has declined to 0.28% from 0.37%, while the Vanguard FTSE Emerging Markets (VEE) now charges 0.33%, down considerably from 0.49%. Tiwari says these fee reductions were the result of some growing economies of scale, and the new relationship with FTSE: Vanguard did promise that lower index licensing fees would be passed on to investors. But I can’t help but think  competition also played a role: iShares’ new international and emerging equity funds were launched with very low fees (0.30% and 0.35%, respectively) and it’s probably not a coincidence that Vanguard’s products are now two basis points cheaper.

{ 123 comments… read them below or add one }

Canadian Couch Potato November 26, 2013 at 9:06 pm

@Dave: Thanks for the comment. I do worry that a lot of other investors are buying US-listed ETFs without paying attention to currency exchange. Even if you’re aware of the costs, there’s no simple solution. Norbert’s gambit can be complicated, and it’s not practical unless you’re exchanging fairly large sums. So good on you for recognizing that.

If you’re at Questrade and you’re buying and selling without commissions, it’s probably worth using separate ETFs for US and international equities rather than using XWD. Have a look at VUN and XEF: both provide better diversification and lower cost than XWD.

Dave November 26, 2013 at 9:10 pm

Thanks very much for replying!

I had considered VUN and XEF, but do you think I’m losing out on a lot of potential by skipping emerging markets? They seem like such an important part of a healthy portfolio.

Canadian Couch Potato November 26, 2013 at 9:14 pm

@Dave: I don’t suggest dropping emerging markets: I was suggesting that 20% VUN and 20% XEF is likely a better choice than the 40% holding in XWD. The 10% in XEC and everything else can stay just as you outlined.

Dave November 26, 2013 at 9:15 pm

Oh! I misunderstand, that makes sense now. Thanks!

Matthew November 26, 2013 at 9:15 pm

@Dave: I am also looking at Mawer Balanced, specifically for a RESP account and a non-registered investment account.

@CCP: I think I read elsewhere on your site that with RESP, and accounts with less than $50k, it’s better to find a low fee mutual fund, is that true? Have you looked at the Mawer funds? For the RESP in particular, the Balanced Fund or even Global Balanced Fund looks alright. No rebalancing required. Seems easy and the MER is at about 1%.

Canadian Couch Potato November 26, 2013 at 9:30 pm

@Matthew: Yes, I definitely agree that low-cost mutual funds are preferable to ETFs for small accounts (which includes almost all RESPs). Even as a committed index investor, it’s hard to find fault with the Mawer Balanced Fund, which is priced like an index fund, is globally diversified, and has a long history of prudent management.

You may also find this interesting, though it’s not an option for RESPs:
http://canadiancouchpotato.com/2013/09/12/the-one-fund-solution/

Holding a balanced fund in an RESP is ideal in the early years, but as the child gets closer to high school a 60% equity mix is likely too aggressive. You can’t the change asset allocation when you hold a balanced fund. However, you can simply add a cash component to the RESP and use that to control the overall mix: for example, you could lower the risk by keeping 70% in a balanced fund and 30% in cash.
http://canadiancouchpotato.com/2010/11/05/taking-risk-in-an-resp/

In a non-registered account, balanced funds are quite tax-inefficient because of the large bond component. Not a big issue if the account is small and you’re in a low tax-bracket, but certainly a concern for some investors.

Matt November 28, 2013 at 12:42 pm

Seeing that VUN and Mawer Balanced Fund both won a Morningstar award last night, sounds like both are decent choice.

With the recent predictions that the Cdn dollar will be at below 90 cents by the end of next year, I wonder if that is another good reason to invest in the US – VUN or VTI.

Ross November 28, 2013 at 8:48 pm

@Dave,

RE: your concerns about forex costs at Questrade. Vitual brokers allows you to
hold U.S. $’s in registered accounts for $50 per account. Therefore, you can
make purchases from the U.S. $ accounts and receive U.S. $’s into these accounts
without having to go through forced conversions. This is another option for you to
investigate. You can see this under administration fees from the VB homepage.

Good Luck,

Ross

Brian November 28, 2013 at 9:17 pm

@Ross Questrade does support USD RSP’s. In Dave’s situation though, I think he should stay simple and stick with Canadian ETFs as @CCP suggested if he doesn’t want the hassle.

sn December 9, 2013 at 10:38 am

For VUN, will it cost me only one level of withholding taxes (15%) if I have it in an RRSP account? Also, I have $50000 in TFSA between my wife and I, and $22000 in RRSP. Would it be wise to put bond etfs in RRSP account first, and then US equities? Thanks.

Canadian Couch Potato December 9, 2013 at 12:37 pm

@sn: Yes, only one level of withholding taxes on VUN. Your other question is hard to answer without complete details, but the short answer is, it probably makes very little difference at this stage. Asset location is much more important when the choice is between registered and non-registered accounts. The RRSP vs. TFSA question is less important.

ETFinvestor December 21, 2013 at 7:43 pm

Are you at all concerned that VCN’s market cap is just $20 million?

ccpfan December 21, 2013 at 8:42 pm

@ETFinvestor: VCN is barely a few months old! Give it a chance.

My opinion: It is the best Canadian ETF you can wish for.

Erin January 2, 2014 at 12:03 pm

I’m still a little confused by VUN vs VTI. I would like to buy one and have it sit in my RRSP for the next 15 years. Which is the better long-term choice?

Canadian Couch Potato January 2, 2014 at 12:17 pm

@Erin: If you are making only the initial purchase and never adding new money for 15 years, then VTI will almost certainly end up being the better choice, even if the currency conversion is costly at the beginning. If you are adding new money to it every year, however, chances are the transaction costs will exceed the savings you’d get from the lower MER and the withholding taxes. More here:
http://canadiancouchpotato.com/2013/12/09/ask-the-spud-when-should-i-use-us-listed-etfs/

Rob T January 13, 2014 at 7:48 pm

Are the only costs of hedging the MER, TER, and tax treatment mentioned in this post?
Hedging seems to cause tracking errors that are much much higher (see http://www.canadiancapitalist.com/why-currency-hedged-funds-have-large-tracking-errors). You reviewed the research paper referred to in the link (according to a comment from CPP on that blog). What were your conclusions?

Canadian Couch Potato January 14, 2014 at 8:50 am

@Rob T: Currency hedging costs do not show up in the MER or TER. The actual transaction cost of hedging is very low: it’s the cumulative tracking error that is the true cost. (The tax inefficiency is also a concern in non-registered accounts, of course.) I have long argued that currency hedging is usually unnecessary for long-term investors for that reason.

Rob T January 14, 2014 at 8:39 pm

@CCP: Sorry, I meant hedging costs showing up as the difference in MERs (between the hedged and unhedged versions of a fund), not the MERs themselves.

These tracking errors occur when the a funds currency hedge differs from the value of its foreign stocks (due to stock price fluctuations). But wouldn’t this kind of tracking error tend to even out over time (as opposed to being cumulative)? If a fund inadvertently has foreign currency exposure from time to time, wouldn’t it be as likely to make them an inadvertent forex profit as it would a loss?

How large would you say the performance penalty is for a hedged fund (assuming it is done in an RSP)? Whats the calculation?

Canadian Couch Potato January 14, 2014 at 9:07 pm

@Rob T: There isn’t necessarily a difference in MER between hedged and unhedged versions. VFV and VSP are the same, as are ZSP and ZUE.

You would think the tracking error would even out over time, but that hasn’t been the case. I did the calculations for XSP from 2005 through 2012 for my book, The MoneySense Guide to the Perfect Portfolio. There was a negative shortfall every year, ranging from -0.4% to -3.5% and averaging -1.9%. The good news it seems to be getting smaller, and in 2013 it was positive for the first time (+0.2%).

DF January 18, 2014 at 1:24 pm

Hi CCP:

So I have redone my portfolio (150K), but my challenge is that I have no RRSP room or TSFA room due to DBP.

Knowing that our dollar is low and not wanting to mess with Norbit’s, I decided to take the less tax efficient approach and put VUN and XEF into my RRSP (not ideal due to withholding tax, but the dollar exchange rate drove me to this). I have VCN in my non-registered account and CDZ in TSFA.

I have higher risk tolerance combined with a solid DBP-so have opted out of bonds for now…but will be transitioning 20% over in the next few years.

My thoughts are when the CND dollar improves I may be better positioned to change over to VTI and VXUS in my RRSP, but since I am saving more in my non-registered account, I am assuming I take the decreased 1-2% return due to the tax inefficiency.

Am I nuts?

Canadian Couch Potato January 18, 2014 at 2:06 pm

@DF: You’re not nuts, but I think you may be misunderstanding a key idea regarding currency exposure. The CAD/USD exchange rate has absolutely no effect on the decision between VTI and VUN, or on the choice between VXUS and XEF:
http://canadiancouchpotato.com/2014/01/13/how-a-falling-loonie-affects-us-equity-etfs/
http://canadiancouchpotato.com/2014/01/16/currency-exposure-in-international-equity-etfs/

DF January 18, 2014 at 3:43 pm

Txs CCP;

Guess I am another “Gerry”. So I am in a pickle…from your experience, should I stay as allocated until years end or transition into VTI and VXUS using Norbert’s gambit? I did like the low trading fees of VUN and XEF, but since I have a 18 year horizon before retirement, taking a small loss to ensure right fund allocation for future taxes seems reasonable.

Thoughts?

Brian G January 18, 2014 at 4:30 pm

@DF wrote “My thoughts are when the CND dollar improves…”

Bad assumption. Are you clairvoyant? :) Don’t assume you know what will happen. If anything there are a few strong arguments that it will go lower. 1.) the Canadian dollar was abnormally high compared to it’s historical rates 2.) the Australia Dollar has dropped even more relative to the US Dollar and it’s also seen as a commodity currency, so Canada has quite a bit more to go down by that measure 3.) there is a huge short interest on the Canadian dollar right now 4) the government wants it lower to help manufacturing, so the Bank of Canada won’t jump in to support it with buying.

But even having said the above, I don’t assume I know what will happen. Huge short positions sometimes go south and cause an equally strong rebound. You never know.

This is why having a diversified global portfolio with unhedged ETFs is a good thing at any time. Pick your allocation and ease into it.

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