This year has been another reminder of why international equities are such an important part of a diversified portfolio: in the first 11 months of 2015 the Canadian market was down almost 6%, while international developed markets were up close to 15%.
On December 9, Vanguard Canada launched two new ETFs tracking international equities: the Vanguard FTSE Developed All Cap ex North America (VIU) and a currency-hedged counterpart that uses the ticker VI. These new funds are a welcome addition to Vanguard’s ETF lineup, but they make the choices more confusing, because there are already similar funds on their menu. So let’s try to sort it all out.
First, the background. Vanguard Canada seems to have been put in an awkward position by recent changes to their benchmark indexes. Back in June, their US parent company announced that four international equity indexes provided by FTSE would expand to include mid-cap and small-cap stocks as well as China A-shares. Those were potentially useful changes that added more diversification. However, they also announced that the FTSE Developed ex North America Index would eventually become the FTSE Developed All Cap ex US Index. That means the new benchmark will include Canada.
The changes make good sense for US investors who get their foreign equity exposure with the Vanguard FTSE Developed Markets ETF (VEA), since Canada was the only developed country missing from that fund. But they create a problem for investors who hold the Canadian ETFs using VEA as their underlying holding: namely the Vanguard FTSE Developed ex North America (VDU) and its currency-hedged version, VEF. Right now these funds are useful for Canadians who want to add western Europe, Japan, Australia and other developed markets overseas. But VEA’s index transition is complete (the timeline hasn’t been announced) Canadians holding VDU or VEF will see their home country making up part of their international equity allocation. Granted, it will be a relatively small allocation (about 7% or 8%), but it’s not ideal.
Two new spinoff ETFs
Vanguard Canada could have addressed this issue simply by making changes to VDU and VEF. They could have decided to sell the entire holding in VEA and replace it with other US-listed ETFs that don’t include Canada—Vanguard FTSE Europe (VGK) and Vanguard FTSE Pacific (VPL), for example. But that would have created a potentially larger problem: international equities have appreciated significantly since the Canadian ETFs were launched (VDU has risen in price by some 40% in four years), and such a switch would likely realize large capital gains that would be passed along to investors who hold the ETFs in taxable accounts. So instead Vanguard decided to leave VDU and VEF unchanged—though these ETFs will eventually be renamed to reflect their new index: the FTSE Developed All Cap ex US.
Vanguard Canada has also created two new ETFs that will exclude Canada: the Vanguard FTSE Developed All Cap ex North America (VIU) and the hedged VI. These will be a better option for Canadians looking for more precision in their international equity allocation.
But there’s more: the new funds will get their exposure by holding the stocks directly, rather than via an underlying ETF. This is significant because the “wrap” structure adds an additional layer of foreign withholding taxes, whether the fund is held in an RRSP, TFSA or non-registered account. Unfortunately (though not surprisingly) the ETF will use a sampling strategy for now, until it gathers more assets. That means it will hold only a portion of the 3,500 stocks in the index, which may lead to larger than normal tracking error until the index can be fully replicated.
And what should you do if you already hold VDU or VEF? In a taxable account, if you would incur a large realized gain, it is probably not worth selling your existing holding. But if it’s a registered account and you can switch without getting slapped with a tax bill, it probably makes sense to sell the older Vanguard ETFs and replace them with either VIU (or VI), or the comparable iShares Core MSCI EAFE IMI (XEF). That will allow you to clear Canada out of our international equity holdings and reduce the drag from withholding taxes at the same time.
Any chance VIU might replace one of the underlying holdings in VXC? Would that make VXC more tax efficient?
Great post Dan, as always.
Do you see VIU as a feasible alternative to XEF (after it has successfully overcome the sampling period) ?
@Patrick: Using VIU would indeed make it more tax-efficient, but replacing the current holdings in VXC would involve the same problem with realizing capital gains. This is something that could happen gradually over time, but it’s not likely to be imminent.
@Dimitiris: After the sampling period is over, yes. But I would want to see a year or more of performance to make sure the tracking error is low.
I literally just spent the afternoon looking around at different international ETFs. You posted this too late! :D
Are there any serious issues with underweighting your Canadian allocation for now by the appropriate amount (8% of the Int’l allocation) and continuing to hold VDU until we see how VIU shakes out?
it would be interesting to see how closely the MSCI (XEF) and FTSE (VIU) indexes are. Also I think XEF has a significant investment in EFA. I don’t know whether they are trying to cut that down.
Now all we need is a Vanguard alternative to XEC :p
XEF only has a 6% holding of EFA
Because they are new, these ETFs wont be subject to year-end capital gains distributions (https://canadiancouchpotato.com/2010/12/10/how-to-avoid-paying-other-peoples-taxes/), correct?
@Neil: There’s no need to adjust your portfolio if you hold VDU. If your target for international equities is 20% then the 8% is just 1.6% of the overall allocation. There is no point in underweighting Canada by that tiny amount to compensate.
@Andrew: In theory any capital gains realized during 2015 would be distributed to investors at the end of the year. But in practice a brand new fund has no opportunity to realize gains.
I really don’t like this given the large gains in VDU to date Presumably they need unitholders approval to change the composition of the fund/benchmark index, and I for one intend to vote against this change.
just saw that they have already obtained unitholder approval, so I guess we’re stuck with this change…
A little off topic, but was wondering if anyone knows of a site that tracks institutional buying of certain Canadian etf’s. (stock and etf screeners?)
I know some screeners do american etf,s anyone know of a good Canadian one, interested in knowing percentage of a etf owned by institutions(smart money).
Thanks in advance.
This change also effects holders of VEA. But I believe you addressed the over weighting concern in your answer to Neil or am I missing something?
@mark. The Pension Investment Assoc. of Canada (PIAC) publishes a fairly detailed table showing the average asset allocation among all the big pension funds in Canada. I always find it a useful reference, though it’s not a screening tool that drills down down to individual securities. The asset allocation reporting put out by the Canada Pension Plan is worth a look as well.
https://www.piacweb.org/publications/asset-mix-report.html
Hi Dan,
Thanks for the update on VIU/VI. I currently hold XEF in my RRSP which has a similar MER to that of VIU. I just check XEF’s holdings and as of Dec. 10 there are 1870 holdings. You imply above that VIU will eventually hold 3,500 stocks once it is accurately tracking its index, would it then be a better option than XEF based on increased diversification?
@Laura: Yes, the index changes would affect holders of VEA as well. As with VDU, the Canadian allocation is not ideal, but it’s not worth switching unless there are no tax implications and you are planning to make trades anyway, perhaps during rebalancing.
@Mike: The once you reach a certain threshold (and I think 1,870 stocks crosses that threshold) adding additional stocks has negligible effect on diversification. As long as both indexes cover large, mid and small caps they should show relatively similar performance over the long term.
@Mike,
Keep in mind that XEF tracks MSCI EAFE Investable Market Index (https://www.msci.com/documents/10199/595e53a9-a3ed-4d0d-817d-dab6b48353d7) which supposedly has 3,044 constituents. So one could say that XEF hasn’t yet grown to cover the full index either.
Hi Dan,
Due to their respective management fees (mf), is investing in a combination of VIU (mf of 0.20%) and VUN (mf of 0.15%) a better option than investing in VXC (mf of 0.25%), if the management estimated fee of VIU be sustainable? Or should we expect VXC fees to decrease on a short/mid term horizon?
@Sebastien: Remember that VXC also holds emerging markets, so you would need to a third ETF to the mix. Holding these three ETFs instead of VXC would give you a lower MER, but would also result in more trading commissions and more frequent rebalancing.
@Juan Refrito,
Thanks for the information i will check it out. In my mind although the white paper on Preferred Shares did not give a glowing report, was wondering in my mind what % of institutional investors would be feeding on BMO preferred ETF ZPR? That’s why i wanted the information.
Extremely beaten down, paying a 6 percent yield on asset, and with interest rates poised to go higher in states, Canada may follow, and these rate reset preferred should increase in value plus the big distributions per month. Yes you shouldn’t try and time market, but these look way oversold.
How do you find out which ones of Vanguard Canada ETFs are holding stocks directly, and which ones are wrappers around US ETFs? I can’t find where they publish that info.
Is there a list somewhere of Canadian ETFs that hold international shares directly ?
I know of XEF, and now VIU, but are there others ?
@Jack: You can find this information on the fund’s web page. On the page for VDU it says: “Invests primarily in the U.S.-domiciled Vanguard FTSE Developed Markets ETF.” In the case of VIU, because it is new, I contacted Vanguard and was told it would hold the stocks directly.
@Nick: I’m not aware of any published list. I usually just look at each fund’s web page one at a time. ZEA also holds (most) stocks directly, as does CIE if you prefer fundamental indexing.
Regarding ZEA, which I hold, in November this year I was annoyed to note that in BoM’s listing of ZEA’s holdings, iShares MSCI EAFE ETF was at the top of the list comprising 10+% of capitalisation. Given that their stated intent had been to hold all foreign assets directly, I wrote to them to ask what was going on and got this reply:
(quote)
Thank you for contacting BMO ETF, reagarding to your inquiry about the holdings of iShares MSCI EAFE ETF, we use this as a liquidity vehicle to manage inflows or outflows into and out of the fund. It generally varies between 2% and 10% weight. The advantage is that we don’t have to trade international equities on each cash flow, which reduces trading costs and benefits tracking.
Best Regards,
______________________________________________________________
Chang (Chris) Liu | Sr. Advisor Service Rep
Wealth Management Product Operations
BMO Exchange Traded Funds | 250 Yonge St., 9th Floor | Toronto ON M5B 2M8
(unquote)
I was somewhat dubious, given that the 10% at the time was at the top of the stated range. However, lately I note that the percentage of MSCI EAFE ETF has been 3.83%, so indeed, the previous higher percentage seems to have been merely a transient thing, and their procedure appears to be an acceptable practicality.
(There are no other non-direct ETF holdings in ZEA, either, which is a good thing).
Hi Dan, is there a difference in terms of withholding tax between VEA and VIU. Reading back, I think International tax applies to both but not recoverable in either. Thanks
@kevin: That’s a complicated question, as it depends which type of account. Please refer to our white paper linked here. VEA is what we have labeled a “Type D” fund, while VIU is “Type F.”
Thanks. From your article above I thought there would be less withholding tax in VIU if held in an RRSP account but reading the white paper there are no difference between VEA and VIU if held in an RRSP. Not sure if it makes sense to switched as the MER is higher in VIU.
Thank you for the update on these new products!
Would you recommend waiting to invest in VIU until the fund has had a little time to get up and running?
@Phil: Yes, that’s usually a good idea unless the underlying holdings are other well-established ETFs. I would check in after a year and see how well it did tracking the index.
Hi Dan,
QXM is an ETF I’ve been reading/researching a lot on because of it’s good return since it’s creation. As I’m sure you know, it’s an ETF that follows the Québec Morningstar/National Bank Index. The Mutual Fund it copies has beaten the S&P/TSX since it’s been created in 99′, returning 12,01% a year.
Here’s the Mutual fund: https://www.bnc.ca/content/dam/bnc/fr/particuliers/investissements/solutions-d-investissement/nos-solutions/solutions-gerees-fonds-communs-de-placement/fiches-fonds/860.pdf
The problem with QXM is that the MER are of 0,58% vs 10 times less for a S&P/TSX all cap ETF. Considering the TSX has over 30% in the Finance industry and more than 19% in Energy, wouldn’t QXM be more diversified than the whole Canadian Market though it has only 60 holdings vs over 250 for TSX?
Another question I have about it is that it was created by First Asset Management, and since it’s been bought by CI Financial recently, I was wondering what were your thoughts about the chances of QXM closing following that. The Caisse de dépôt invested in it when it was funded so I’m sure they’d have
Third query I have about it is the liquidity of QXM. Do you think it could be a significant risk involved with this ETF?
I’m really considering about putting the proportion of this year’s new investments reserved for Canadian equities in QXM. What are your thoughts?
Thanks in advance, I really enjoy your blog!
@Étienne: Thanks for the comment. I generally recommend that investors use very broadly diversified funds rather than those with a narrow focus. QXM may have reasonably good sector diversification, but with all of its companies headquarters in one province of one small country, it has a different kind of concentration risk. It’s hard to understand how the past performance should be expected to persist.
Hi Dan,
With funds such as XEF and VIU, do you still see an advantage to holding US ETFs (such as VEA) in a RRSP? The expense ratio is slightly lower which may be counterbalanced with the need to use Norbert’s Gambit. The advantage I could see would be if the US has more advantageous tax treaties for lower withholding taxes. Thanks!
@Fred: You have it exactly right. Because of the lower MER and lower withholding tax rates VEA would still be slightly cheaper in an RRSP if you can overcome the cost of the currency exchange. But the difference is likely to be quite small.
Hi Dan – I can’t tell you how important this post was to me. I have large holdings in VEA (in registered accounts) and could easily have missed the impending change and hold more Canadian equity than I wish. For some time I’ve been considering switching from VEA (MER 0.09%) to a split between VPL and VGK (both MERs 0.12%) because I was thinking that the benefit of annually rebalancing between Europe and the far east would outweigh the extra 0.03% in fees. What do you (or any other reader) think about the trade off between rebalancing and 0.03% extra fees over the long haul?
I wonder if I now have 2 good reasons to move to VPL/VGK in my tax sheltered accounts. Thanks.
@Noel: Thanks for the comment. To be honest I think this is pretty small decision. Saving 0.03% amounts to $30 per year on a $100,000 holding, and even that can easily be wiped out by a couple of additional transactions or some random tracking error. The annual rebalancing might offer some advantage, but over some periods it would work against you. If you need to make some trades in the account anyway, then sure, make the switch. But overall, not a decision I would worry too much about.
Hi Dan, I am looking the new ETF VI and have a couple of questions:
Why is the management fee the same as VIU (since VI is hedged I thought there would be additional costs)
Reading the fund details, is is saying it is hedging the exposures to the USD? But this is an international fund and the exposures should be CAD to various other countries in Europe and AP?
@Kevin: Currency hedging costs are not included in the MER: they are a transnational cost. The cost for this is very low (maybe a basis point or two, at the most) although imprecise hedging can lead to a drag on performance.
You’re right that there should bu no USD exposure in VI, so I suspect that is an error on the Vanguard site.
@CCP:
I’m surprised at your comment on the cost of hedging (1 or 2 bps “at the most”). I’ve read much higher estimates, more in the order of 40-50 bps (Dan Hallett, I think, on the Financial Webring Forum). That’s a substantial spread. Is there a way of narrowing it down??
@KISS: We might be talking about different things. Currency hedging can easily add 40 to 50 bps in tracking error if it is imprecise (it can much more). But the actual cost of trading the currency forwards is not that high. Can you can direct me to the specific comment you’re referring to?
Given Japan’s aging population and lackluster economy, wouldn’t VIU be doomed from the start with a Japanese allocation of 23.65%?
@cn_habs: These risks are well known to the investment community. According to (my understanding of) the efficient market hypothesis, the current prices of Japanese equities already take into account the future risks from demographic decline and expected weak economic growth. That is, their prices are lower than equivalent companies’ share would be in another market. As a result, Japanese equities’ future performance should roughly match other markets’. There are, of course, many other factors to take into account, including the fact that many Japanese companies are strongly export oriented, so their share prices are affected by the economic prospects of their export markets, as well as the domestic economy.
In other words, it’s complicated. However, as a couch potato investor, that’s someone else’s problem; you just have to buy index funds that mirror each market’s capitalization.
@pjb: “In other words, it’s complicated. However, as a couch potato investor, that’s someone else’s problem; you just have to buy index funds that mirror each market’s capitalization.”
Nicely stated. It takes deep insight not to be too clever.
This draws attention on an area often missed by investors who have large positions in taxable account – the stability of financial products may have major implications on taxes years into the future.
If a ETF folds, you maybe forced to realize hundred of thousands of capital gain.
What if you held VXUS in your registered accounts – Do you recommend switching to VIU, given how much the USD has appreciated against CAD (if it makes a difference, I guess it would not.)
@Tony: VIU is not a good substitute for VXUS, as the latter includes emerging markets and well as developed. In any case, as you have anticipated, the USD/CAD exchange rate has little or no effect on the performance of VXUS:
https://canadiancouchpotato.com/2014/01/16/currency-exposure-in-international-equity-etfs/
Ahh I see. So you’re saying they’re 2 different funds since VXUS includes emerging markets. I thought I could replace VXUS with VIU as it would be easier to buy funds in CAD than USD, but now that you mention they are 2 different funds I think I will keep VXUS.
Hi Dan. I am now retired, and will have a some money to invest in about 6 months, in a non-registered account. For tax efficiency (and simplicity) purposes, which ETFs would be most appropriate for a non-registered account? I want to have a globally diversified mix, probably 50/50 between fixed income and equities, with equities at 1/3 each for Canadian, US and international/emerging markets.
@Jean: The equity ETFs in my model portfolios are fine for non-registered accounts. When it comes to fixed income, however, it is best to avoid traditional bond ETFs such as VAB in taxable accounts. A GIC ladder is often a more tax-efficient option, as long as you do not need liquidity (GICs cannot be sold before maturity). There are also more tax-efficient bond ETFs such as ZDB, BXF and HBB. More info here:
https://canadiancouchpotato.com/2014/05/08/a-tax-friendly-bond-etf-on-the-horizon/
https://canadiancouchpotato.com/2014/11/19/ask-the-spud-bond-etfs-in-taxable-accounts/
https://canadiancouchpotato.com/2015/03/03/which-bond-etf-is-most-tax-efficient/
Hi Dan,
I was wondering if you plan to make any changes to your model portfolios for 2016. Also, this year Canadian equity was quite a disappointment and that will probably lead to negative returns this year right?