ETF Choices Are Less Important Than You Think

August 20, 2013

The comments following my recent post about new ETFs from Vanguard were another reminder of just how often investors get overly focused on products. I accept part of the blame here, since I write a lot about the relative merits of specific funds. But I want to be clear that the choice between similar ETFs or index funds is not nearly as important as many people believe. In many cases, it’s trivial.

Successful investing is about saving regularly, keeping costs and taxes low, diversifying broadly, and sticking to a plan. For index investors, selecting appropriate ETFs is important, but it should only come at the end of the planning process. These important steps should come first:

1. Determine the asset allocation appropriate to your goals. This is the most important decision of all, as it will determine your portfolio’s expected risk level and expected rate of return. My model portfolios are all based on a mix of 60% equity and 40% bonds, which isn’t appropriate for everyone. The right mix of stocks and bonds for you depends on your current savings rate and your ability, willingness and need to take risk. Do this part properly you are at least 75% of the way there.

2. Decide which account types are best for your situation. In most cases, long-term investors should only use non-registered accounts after their RRSPs and TFSAs are maxed out. Most people can’t max out both registered accounts, so they should choose a priority.

3. Determine the most efficient asset location. If you’re investing across registered and non-registered accounts, you should pay attention to where you hold each asset class. The least tax-efficient asset classes should go in your RRSP or TFSA and the most tax-efficient in your non-registered accounts. (If you have a spouse, it typically makes sense to think of all family accounts as one large portfolio.) I can’t stress enough that asset location decisions should be based primarily on income tax, not foreign withholding tax. Justin Bender explains why in this example.

4. Make a shortlist of ETFs or index funds for each asset class. At this stage your focus should be on the ETF’s strategy. For now you’re asking questions like this: Do I want to hold a total-market US equity fund, or one that includes only large caps? For international equities, do I want developed countries only, or emerging markets, too? Do I want a broad-based bond fund, or does my plan call for short-term bonds only? Cap-weighted indexes or some alternative? A good place to start your search is my list of recommended ETFs and index funds.

5. Choose the best product from your shortlist. Only now, after you’ve narrowed your choices to a handful of appropriate ETFs, does it make sense to dig deeper to see if one offers a genuinely meaningful advantage. You should consider, in order of importance:

  • The potential for US estate taxes
  • Your cost of converting currency (if the shortlist includes US-listed ETFs)
  • The impact of foreign withholding taxes
  • The difference in MER (a few basis points is meaningless)
  • Whether your brokerage offers one or more of the ETFs commission-free

Let’s say you’ve narrowed your US equity choices to either the Vanguard Total Stock Market (VTI) or its new Canadian equivalent, the Vanguard U.S. Total Market (VUN). How do you know which ETF is the better option?

  • VTI may be subject to US estate taxes, whereas VUN is not.
  • VTI trades in US dollars, which is extremely costly unless you’re able to reduce the cost of currency exchange.
  • In an RRSP, you will pay a 15% withholding tax on dividends if you use VUN (this works out to a cost of 0.30%, assuming a 2% yield). With VTI you would be exempt from this tax. In a non-registered account or a TFSA, the two funds are equivalent.
  • VTI has a lower management fee (0.05% versus 0.15%). That difference works out to $10 a year on a $10,000 investment.

Clearly the right decision for you may not be appropriate for another investor. And some of the criteria are subjective: for example, VTI might be cheaper overall, but you might be willing to pay a bit for more for the convenience of trading in Canadian dollars.

But here’s the larger point: if you’ve made good decisions during the first four steps in this process, this final step is really not that important. We’re often talking about a difference of 10 or 20 basis points a year on one asset class in a diversified portfolio. In a five-figure portfolio the impact is almost certainly trivial, and it should never delay you from implementing your plan. In a larger portfolio it’s worth considering carefully, but only after you’re sure you got the first four steps right.

{ 42 comments… read them below or add one }

Andrew August 20, 2013 at 8:12 am

At this point, the problem isn’t a lack of ETFs to choose, but a lack of tools to use for easily and inexpensively contributing to them. With a savings account, you can just throw the money at it and let it manage itself; there is nothing that would allow someone to do that with a set of ETFs, having chosen an appropriate asset allocation. This is utterly ridiculous, as it’s something that a computer could handle very easily. It appears from their website that Vanguard provides such services within the United States; it would make an enormous difference if they would bring those here, and cut out the broker as a middleman.

Danno August 20, 2013 at 9:11 am

@Andrew: There are sorta tools like that. ING offers those Streetwise mutual funds, which might not be great for an advanced investor, but for a beginner or someone starting small, with small, regular contributions, they are pretty ideal. In the ETF space, iShares offers there “Portfolio Builder” series and while, for the record, I am not a huge fan of them, they somewhat do what you are suggesting. Imperfect options, I know, especially for a more advanced investor, but some do exist. It seems to me as though, once most investors get to larger portfolio sizes and/or more mature in their understanding, they are less likely to have issue with managing a few transactions a year themselves. Just my thought.

Doug Cronk August 20, 2013 at 10:24 am

Exactly! Getting the asset mix right adds the most value. Products matter but at the margin.

My Own Advisor August 20, 2013 at 5:30 pm

Great post Dan, a good reminder for all investors.

Planning trumps product selection.

Mark

claire August 20, 2013 at 11:33 pm

Thanks for the well needed review.

Noel August 21, 2013 at 1:26 am

I was in Australia earlier this year and helped a friend of mine get set up with Vanguard Funds, who have been in Australia about twice as long as they have in been in Canada. They have these Lifestrategy funds that are made up of the individual Vanguard Funds with appropriately low MERs and they do all the rebalancing. You just pick one of the pre-set mixes you want. I think in the US Vanguard also has similar funds but the mix also changes as you age with the equity % going lower as you grow older. Again they do all the rebalancing.

It would be fantastic if they had these in Canada.

Brian August 21, 2013 at 3:00 am

@Andrew, you may want to look into low cost mutual funds if you want to do regular contributions split between asset classes. For example, with TD e-Series you can do a pre-authorized purchase plan to achieve close to what you are after. Or look into a low cost balanced fund for ultimate ease. For low dollar contributions, mutual funds are the best way to go because of their fractional units… as long as you stick with the very low cost funds.

If you do want to go the ETF route, it’s not that hard to allocate a contribution to the right fund(s.) If your regular contributions are relatively small compared to portfolio size, and you pay a commission to buy ETFs, then a simple idea might be to just contribute to whatever one ETF is most underweighted at the time of the contribution. This is simple and will keep trade commissions low.

Baph August 21, 2013 at 11:35 am

@Andrew, you can use very handy spreadsheets from here: http://canadiancouchpotato.com/2012/03/15/a-spreadsheet-to-manage-multiple-accounts/
or like Brian suggested earlier just put money in the most underweighted ETF.
Also, you can buy ETFs commission-free with Questrade, so you don’t have to worry about any extra cost if you contribute small amounts often.

Frank August 21, 2013 at 11:38 am

Brilliant article, definitely alleviates my fund-picking worries a bit as I am currently stressing over every little aspect of my fund selection.

Thanks again Dan!

David August 21, 2013 at 10:57 pm

… in other words, buy and HOLD. Thanks for the ongoing confirmation, as usual, Dan.

Brunnenburg August 23, 2013 at 11:52 am

I encountered an unexpected bump in my USD holdings in my margin (i.e. non-registered) account with Questrade. Perhaps someone could clarify the following issue? After maxing out my and my wife’s RRSPs and TFSAs, I purchased a large position of EWC (iShares MSCI Canada Index), the ETF that tracks the Canadian index in USD. However, when I looked up the dividend distribution last week in my Questrade account, I noticed that they had applied the foreign withholding tax of 15%. Why is that? I know I’m trading in the NYSE, but wouldn’t I be exempt from the FWT as a Canadian?

Thank you.

Canadian Couch Potato August 23, 2013 at 12:13 pm

@Brunnenburg: EWC is a US security, even though its underlying holdings are Canadian companies, so the foreign withholding tax applies. In fact, there may even be two levels of withholding tax, since the iShares fund itself is likely hit withholding tax by the Canadian government. This is the same issue a Canadian encounters when buying a US-listed ETF that holds international stocks.

HXT.U is another option. It’s denominated in USD, but it’s a Canadian-domiciled fund. Just make sure you understand the swap structure:
http://www.horizonsetfs.com/pub/en/etfs/?etf=HXT.U&tab=overview

Brunnenburg August 23, 2013 at 12:30 pm

Dan, thanks for the prompt and thorough reply. Would I nonetheless be able to claim credit for the foreign withholding tax on EWC (or any other US-listed ETF) when I file my income tax return?

I just had a look at HXT.U. It looks like an interesting option for a non-reg account, as it doesn’t pay any dividends as far as I can tell. I suppose one would just re-balance as needed. The bid-ask spread seems fairly tight, but I notice that it has essentially no volume. It’s showing 0 today! Is that an issue at all to consider?

Canadian Couch Potato August 23, 2013 at 12:42 pm

@Brunnenburg: You should be able to recover your share the withholding tax if it shows up on your T-slip next year. You would not be able to recover the withholding tax paid by the fund itself, however.

I would not be concerned about the low volume of HXT.U. Just make sure you use a limit order so you don’t get any surprises!
http://canadiancouchpotato.com/2012/09/10/etf-liquidity-and-trading-volume/
http://canadiancouchpotato.com/2012/09/13/an-etf-pricing-puzzle/

Brunnenburg August 23, 2013 at 12:44 pm

I found this interesting and recent fact sheet from Horizon, which compares HXT.U, XIU, and EWC:

http://www.exchangetradedforum.com/documents/presentations2013/Vancouver/1040-JaimePurvis.pdf

I like the “no dividend tax liability” and no swap fee.

Brunnenburg August 23, 2013 at 12:45 pm

I looks like HXT.U is indeed a better option. Many thanks!

Canadian Couch Potato August 23, 2013 at 12:49 pm
Brunnenburg August 23, 2013 at 1:05 pm

Fantastic. The last link in particular saved me from making yet another mistake: I was going to buy VTI in my non-reg account in the next pullback. I see now that I’m much better off with ZSP.U.

This blog is a treasure-house of information!

Brunnenburg August 23, 2013 at 1:13 pm

One last question, if I may. I don’t suppose there is a USD Canadian-domiciled version of VWO, VEA or any total international equities ETF, is there? Gratitude.

Canadian Couch Potato August 23, 2013 at 2:21 pm

@Brunnenburg. No, there are no Canadian-domiciled USD-denominated international ETFs.

Russell August 24, 2013 at 11:54 am

Hi Dan. I follow the complete couch potato but I’m going to get more aggresive. 70% equities and 30% fixed income. I’ll add 10% in VTI. How would you recommend removing 10% in bonds? I’m currently at 30% XBB and 10% XRB. Thanks for your great work!

Canadian Couch Potato August 24, 2013 at 12:16 pm

@Russell: It probably won’t make that much of a difference in terms of overall portfolio volatility. You could go 25% XBB and 5% XRB, as long as your portfolio is large enough to justify a 5% holding in any asset class (with a small portfolio, the dollar amount would be trivial). Another option would be to just drop RRBs and keep the portfolio simpler. For what it’s worth, in my own portfolio I use 20% nominal bonds and 10% real-return.

Andrew Coyne August 25, 2013 at 10:32 am

I still can’t figure out how to weight these different considerations. I want to hold US ETFs in my RRSP, but I bank at TD so can’t hold them in US$. I don’t plan on doing anything further with them for many years, other than reinvesting the dividends. So should I buy the Canadian equivalent, and get hit by the withholding tax (plus the higher MER), or buy the US version, and eat the costs of exchange? Which is worse, in the long run?

Canadian Couch Potato August 25, 2013 at 11:06 am

@Andrew: There is no simple answer to that question. Overall, the US-listed ETFs are likely to be more cost-effective over the long run only if you can avoid the high cost of converting Canadian dollars to USD to make the initial purchase and the eventual sale. The problem is, the cost of that currency exchange varies widely. If you’re paying 1.5% each way (typical of many brokerages on transactions under $50K) then US-listed ETFs are probably a poor choice. If you can use Norbert’s gambit or some other method to reduce that cost to 0.2% to 0.3%, then US-listed ETFs are far more appropriate.

Andrew Coyne August 25, 2013 at 11:13 am

Okay, thanks for getting back to me. So the VTI and whatnot that you have in your model portfolio: are you holding that in US$ and using Norbert’s gambit (which I still don’t fully understand)? Or can you hold a US-listed ETF in Canadian dollars? (Possibly a dumb question.)

Canadian Couch Potato August 25, 2013 at 11:28 am

@Andrew: VTI and VXUS and all US-listed ETFs are traded in US dollars. It is not possible to trade a US-listed ETF in Canadian dollars.

You don’t need to use Norbert’s gambit to convert Canadian dollars to US, but it is often the best way to avoid the large spreads brokerages charge. On very large sums (at least $100K) you may be able to get a comparable rate by calling the brokerage.)

Honestly, if all of this seems confusing, it is probably best to simply use the Canadian-listed versions. That’s especially true if you’re at TD, because brokerages that don’t allow you to hold USD in an RRSP make it even harder to manage.

John P August 26, 2013 at 11:20 pm

I can confirm that it is possible to hold US$ at TD. You need to call them the first time to set it up….just tell them to allow “wash trades” for your account. This means when you sell a US$ security, the proceeds wash into TDB166 which is a US$ money market account. Then if you purchase a US security, TD will automatically take funds from TDB166 instead of doing a forced currency conversion from the C$ side of the account.

Within an RRSP, Norberts Gambit is easily executed at TD. Also it can all be done online with no need to call them to “journal shares” over to the US side or anything like that.

Andrew Coyne August 27, 2013 at 2:48 pm

Huh? How can you do a Norbert’s Gambit in a TD RSP, if it won’t let you hold US$? On the other hand, I see (from trying it out online last night) that I *can* buy US-listed ETFs like VTI in it — only they’re valued in C$, I guess…

Andrew Coyne August 27, 2013 at 2:49 pm

Or (sorry) is your point that the US$ proceeds from a Norbert’s go into TDB166 (provided you’ve had the foresight to set it up)?

Andrew Coyne August 27, 2013 at 2:56 pm

So, if I’ve understood all this correctly, the process for buying (and holding) US-listed ETFs inside a TD RSP, without incurring a lot of exchange costs, is as follows:
1) Get a TDB166 US$ money market account, with wash trades activated.
2) Do a large Norbert’s gambit, to get the US$ into the TDB166. This can apparently be done online, for example by buying DLR on the Canadian market and selling it on the American, without having to phone anyone.
3) Buy the US-listed ETFs with the US$ in the TDB166 fund, to which any US$ dividends would also “wash” back.
Have I got all that right?

John P August 27, 2013 at 11:19 pm

Hi Andrew, You’ve basically got it, just a couple of minor clarifications…

1) you don’t need to “get” a TDB166 account, as soon as you ask them to enable wash trades, any proceeds from the sale of a US security will automatically “wash” into TDB166
2) yes, or you can also use a cross-listed stock such as POT, TD, BB, etc. Buy on TSX, then immediately sell on NYSE (can easily be done in less than a minute)
3) correct. If you purchase a new US security, TD will automatically use funds from TDB166

Que September 4, 2013 at 6:27 pm

@Dan: You say, “In a non-registered account or a TFSA, the two funds are equivalent.” Therefore if somebody has maxed their RSP, the ideal location of VTI, which type of account and fund combo would be ideal, non-reg versus TSFA and VTI versus VUN?

Canadian Couch Potato September 4, 2013 at 6:33 pm

@Que: I think it’s important to stress that foreign withholding taxes are only one part of the equation. If you have TFSA room, I can’t think of a good reason to keep US equities in a non-registered account, where dividends are fully taxable as income and capital gains are also taxed.

In a TFSA the withholding tax is lost whether you use VTI or VUN. In a non-registered account, it is recoverable in both funds. So the decision comes down to whether or not you are comfortable trading in US dollars.

Jamie September 28, 2013 at 9:23 pm

Hi Dan,
Do the above principles apply equally to a high net-worth investor with registered and non-registered investments? As you know, banks offer separate active-investment services for these investors at slightly better rates than the average actively managed mutual fund. However they’re still at least 1-1.5% more expensive than a DIY approach.

Do you feel there is an incremental benefit to pursuing this active management (presumably they get more complicated than stocks/bonds/REITs) over the DIY approach – assuming the latter is managed well from a tax perspective. Or, is simple ETF-based passive low-cost investing the best approach, even for HNW investors who presumably (?) have options available besides standard active-management?
Thanks!

Canadian Couch Potato September 28, 2013 at 10:28 pm

@Jamie: Thanks for a great question. I don’t think active investment management is likely to add value no matter what the account size. After all many pension funds use passive strategies with billions of dollars, and they have access to the best and lowest-cost active management available. However, I do believe good advice is more important for investors with larger portfolios, especially for those with significant non-registered assets. I never assume that DIY investors manage their portfolios in a tax-efficient way, because in my experience most do not!

Jamie September 29, 2013 at 5:05 pm

Dan,
Thanks for the reply. It’s also my understanding fom reading many of the books you’ve recommended, that optimal passive management should outperform active management over the longterm. Articles like “the real secret of the rich” (MoneySense March 2010) may, on the surface, suggest that private investment counsels are preferable to a DIY, low-cost approach.

I’d like to believe that if the important elements like behaviour, tax-management and re-balancing (granted, a big ‘if’) are optimized in a DIY fashion, then the 1-1.5% cost of the counsels would be a performance drag, and simply represent the cost of ongoing management of the funds, and advice.
Thanks again for this fantastic blog. Hope the work with Justin is flourishing.

Canadian Couch Potato September 29, 2013 at 5:15 pm

@Jamie: I appreciate the good wishes. Yes, the work with PWL is going very well. We’ve been able to help a wide cross-section of DIY clients.

In principle, you’re correct that that if a DIY investor can bring the same level of behavioral control, tax management and rebalancing discipline to the table then any fee paid to an advisor would be a drag on performance. But only a tiny fraction of people are capable of doing this—and, really, why would one expect the average DIY investor to have the same depth of knowledge as an advisor who does this kind of work every day?

The problem with the industry is not that advisors charge 1% for good advice. It’s that many charge higher fees for no advice or (all too commonly) bad advice.

JS October 22, 2013 at 2:16 pm

Hi Dan,
I have read the above article few times and totally let it sit in my mind. I used to spend quite some time giving more importance to specific product rather than other imp thing but finally I have use the ladder and build a portfolio for my self and already start buying VSB and ZRE. I have few friends working in banks and I can get USDs through them at no commission to buy VEA and VTI time to time. I am still trying to read the general stuff about all the terms in the market and all your old posts. Now I have to pick a Canadian market ETF and I am little confuses about ZCN and VCN, is there any fundamental difference between these two? Fee diff is just few bps and negligible. I just don’t know which one to include in my portfolio. What would you pick for a long term RRSP considering I will be buying these ETFs 2 times a year with some lumpsum and I am in my early 30s. I am trying to find the diff between FTSE vs. MSCI indexes but I feel I am suffering form analysis paralysis. But I just want to pull the trigger, buy either ZCN or VCN and don’t look back.

Canadian Couch Potato October 22, 2013 at 2:38 pm

@JS: I currently have ZCN in my model portfolios, but I will likely change that to VCN when I next update them. But as you say, there is not likely to me any meaningful difference in the long run (or even the short run). This is definitely not a decision to agonize over.

JS October 22, 2013 at 2:47 pm

Thank You Dan for the quick reply. I will go with VCN.

Mary January 3, 2014 at 4:28 pm

I am new to investing (6 months). Please explain what PWL is? Thank you.

Canadian Couch Potato January 3, 2014 at 4:43 pm

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