Archive | Foreign currency

Taxable Consequences of Norbert’s Gambit

Norbert’s gambit with the Horizons US Dollar Currency ETF (DLR/DLR.U) is often the most cost-efficient way to convert Canadian dollars to US dollars, or vice-versa. Our series of white papers focused on performing the gambit in an RRSP, but if you’re swapping currencies in a non-registered account, you should be aware that it can have tax consequences.

At brokerages such as RBC Direct and BMO InvestorLine, you can place the buy and sell trades within minutes of each other. But several other brokerages do not allow you to journal the ETF from the Canadian side of your account to the US side (or the other way around) until the buy trade settles. In both cases, however, there will be at least three business days for the transaction to be complete, and the US-Canadian exchange rate can move significantly during that time. A big swing could stick you with a capital gain or loss when you make the sale.

What’s more, calculating this gain or loss can be tricky, because both the purchase and sale need to be reported in Canadian dollars. That means any transaction in DLR.U needs to be converted from US dollars.

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Rebalancing With Foreign Currencies

In my last post I argued that Canadians should avoid currency hedging in their equity portfolios. Not only does exposure to the US dollar and other foreign currencies add a layer of diversification, but hedging strategies can be imprecise and ineffective. I ended that article by encouraging investors to simply “use a rebalancing strategy to smooth out the ride.” Let’s explore that idea a little more.

The first point to understand before we go further is that you should measure your investment returns in Canadian dollars, even if some of your assets are denominated in other currencies. Indeed, you’re probably already doing that, especially if you hold US and international equities through mutual funds or Canadian-listed ETFs. The net asset value of these funds is always given in Canadian dollars, and any fluctuations in foreign exchange rates is already factored in. Even if you use US-listed ETFs, most online brokerages display the market value of your holdings in Canadian dollars, but if you’re looking at the funds’ US websites or getting quotes on Google Finance, you may be misled by returns given in US dollars.

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Stepping Back From the Hedge

We’re not quite in “northern peso” territory yet, but the Canadian dollar has taken a beating over the last couple of months. And any time there is a significant move in the markets—whether it’s stocks, interest rates or currencies—investors second-guess themselves. Of course, the financial media is always there to support them with hyperbole, overreactions and short-term thinking.

Investors might now be wondering if they should reposition their portfolios in light of the dollar’s weakness, and the subject of currency hedging inevitably arises. Let’s start with a refresher on how this strategy works.

When you hold US or international equities, you are also exposed to foreign currencies. The exchange rate between the Canadian dollar and these other currencies will affect your returns. Index funds that use currency hedging (these typically have “CAD Hedged” or “Currency Neutral” in their name) attempt to eliminate the effect of exchange rates and deliver the returns of foreign equities in their local currencies. For example, if the S&P 500 returns 10% for US investors, a currency-hedged S&P 500 should also deliver 10% in Canadian-dollar terms, regardless of whether the loonie rose or fell during the period.

A falling loonie is good for your foreign equities

I’ve received questions from investors who are worried the Canadian dollar will fall further and are wondering if they should switch to currency hedged funds for their US and international equities.

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Decoding International Equity ETF Returns

How have international equities performed over the last year? If you research the returns of index funds in this asset class, you may wind up with more questions than answers.

I recently received an email from David, a reader who wanted to know why the recent performance of three international equity index funds looked so different. It’s an excellent question, because unless you understand what’s going on here you’re liable to make a poor decision when choosing one for your portfolio. Exhibit A, their returns over the last year (period ending December 4), according to Morningstar:

TD International Index Fund – e (TDB911)
7.66%

iShares MSCI EAFE Index ETF (XIN)
10.21%

iShares MSCI EAFE ETF (EFA)
1.80%

All of these funds have the same benchmark: the MSCI EAFE Index, which covers developed markets outside North America, including Japan, Europe and Australia. In fact, XIN uses EFA as its sole underlying holding, so the two funds have identical stock exposure. Why, then, is their performance dramatically different?

Peeking over the hedge

Let’s begin with the TD International Index Fund,

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The Couch Potato Goes Abroad

Andrew Hallam’s Millionaire Teacher remains one of the best introductions to index investing. When I reviewed it three years ago, I stressed that Andrew writes with authority because he follows his own advice.

In his new book, The Global Expatriate’s Guide to Investing, Andrew shares more of his first-hand knowledge about managing an indexed portfolio outside your home country. Andrew left Canada in 2003 and spent years as a teacher in Singapore before settling (at least for now) in Mexico earlier this year. So he knows all about the challenges—and the surprising benefits—of being an expat investor.

Most of his book’s advice applies equally to homebodies: the first several chapters lay out the case for using a passive strategy, whether with plain-vanilla ETFs, a fundamental index strategy, or the Permanent Portfolio. Then he explains how expats can put these ideas into practice. I asked Andrew to elaborate on some of the key points for Canadians living abroad.

What are the most important tax issues that Canadian expat investors need to be aware of?

AH: So much depends on where the expat is living.

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US Investors in Canada: What to Watch For

Index investors in the US have always had it easier than Canadians, thanks to lower costs and more choices. Unfortunately, if those investors move to Canada, their plight becomes much more difficult.

Unlike Canada (and virtually every other western country), the US requires its citizens to file an annual return and potentially pay taxes even if they live abroad. The rules may apply even if you were born in Canada and have never lived in the US, since it’s possible to inherit citizenship from US-born parents. For tax purposes, “US persons” don’t even need to be citizens: they can also be Canadian green card holders or snowbirds.

Tax implications for US persons living in Canada are complex and often controversial: if you’re in this situation, you should seek help from an advisor who specializes in cross-border issues. But here’s a heads-up on two issues that have recently come up with clients of our DIY Investor Service who had no idea they were flirting with danger.

Don’t open a TFSA or an RESP. Tax-Free Savings Accounts (TFSAs) and Registered Education Savings Plans (RESPs) offer significant tax benefits for Canadians.

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Why Currency Hedging Doesn’t Work in Canada

In the last two years, Canadian ETF providers have finally launched US and international equity ETFs that do away with currency hedging. Yet the strategy remains hugely popular: the hedged versions of Vanguard’s international and US total market ETFs remain much larger than their unhedged counterparts, while investors have more than $2 billion in the iShares S&P 500 Hedged to CAD (XSP), making it the third largest ETF in Canada.

None of my model portfolios include currency-hedged funds: I’ve long argued the strategy is expensive and imprecise. Even when the Canadian dollar appreciates strongly, the high tracking error of currency-hedged funds often reduces any potential benefit. In one dramatic example, Justin Bender looked at the period from 2006 through 2011, when the US dollar depreciated by almost 13% and hedging should have produced a huge boost: in reality, XSP lagged its US-listed counterpart.

This leads to an interesting question. If currency hedging were free and precise—with an expected tracking error of zero—would it be worth considering?

Does hedging lower volatility?

The most common argument in favour of currency hedging is that it lowers volatility.

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Currency Exposure in International Equity ETFs

My last post explained that Canadian investors are exposed to currency risk any time they hold US equities, even if their holding is an ETF or mutual fund that trades in Canadian dollars.

In my example, Gerry owned the Vanguard S&P 500 (VOO), which is listed on the New York Stock Exchange and trades in US dollars, while his wife Sharon owned the Vanguard S&P 500 (VFV), which trades on the TSX in Canadian dollars. Since the underlying holdings of both ETFs are the same—500 large-cap US stocks—both Gerry and Sharon have the same exposure to the US dollar, even though they’re trading in different currencies. (The exception would be if one chose an ETF with currency hedging, such as the Vanguard S&P 500 CAD-hedged (VSP), which is designed to eliminate currency risk.)

If that idea is confusing, it gets even more fun when you add international equities to the mix. Let’s say Gerry owns the Vanguard FTSE Developed Markets (VEA), an ETF that trades in US dollars and holds stocks from western Europe, Japan, Korea, Australia and many other overseas countries.

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How a Falling Loonie Affects US Equity ETFs

Over the last year the loonie has declined significantly relative to the US dollar: the currencies were at par early last February, but the Canadian dollar closed under $0.92 US on January 10. That has been a benefit for Canadians who hold US equities: not only did the stocks deliver huge returns in their local currency in 2013, but we got a further boost thanks to the appreciation of the US dollar.

Unfortunately, the drop in our dollar has encouraged some ETF investors to attempt to exploit a buying opportunity. Trying to make currency plays is foolish at the best of times, but it’s especially unwise if you don’t fully understand how currency exposure works.

Meet Gerry, who uses the Vanguard S&P 500 (VOO) to get exposure to US stocks. This ETF is listed on the New York Stock Exchange and trades in US dollars. With the greenback riding high, Gerry plans to sell VOO and use the proceeds to buy an equivalent fund listed on the TSX: the Vanguard S&P 500 (VFV). Gerry tells his friends he’s selling US dollars high and buying Canadian dollars low while keeping his equity exposure the same.

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