Last week reader W.B. asked why I recommend US-listed ETFs from Vanguard for the US and international equity components. His brokerage charges a 1.5% currency conversion fee, and W.B. argued that this hefty cost would outweigh the savings he’d get buy using US-listed funds with lower annual MERs.
I knew that the US-listed ETFs would be the better deal over the long run, but I couldn’t be specific about the break-even point, because I had never actually done the math. The calculations aren’t straightforward: in addition to the currency fees and MERs, you also have to consider the different ways each ETF is taxed.
Well, now I have done the math. I created an Excel spreadsheet that readers are welcome to download. I had to make several assumptions, but I have designed the spreadsheet to be flexible: you can easily change the amount invested, the currency conversion fee, the projected returns, and the MER of the funds you’re comparing. (Just be careful not to bugger up the formulas!)
Here’s the thought process that went into building the spreadsheet:
- I have included two worksheets: the first assumes a single lump-sum contribution of $100,000 CAD, while the second assumes a $5,000 annual contribution. You can easily change either amount to suit your circumstances.
- If the brokerage charges 1.5% every time Canadian dollars are exchanged to US dollars or vice-versa, then the investor in the US-listed ETF loses 1.5% on each contribution, and he loses another 1.5% when he cashes out at the end of the investing period. The 1.5% fee also applies to all dividends received from the US-listed ETF.
- The ETFs are considered to be held in an RRSP. Therefore, the US-listed ETF is exempt from the 15% withholding tax on foreign dividends.
- I assume that the Canadian ETF simply holds the US-listed version of the same fund. There are several common examples of this in Canada: iShares XSP doesn’t directly hold the stocks in the S&P 500, but rather holds the iShares S&P 500 Index Fund (IVV). The same goes for iShares XIN, which holds the iShares MSCI EAFE Index Fund (EFA), and Claymore’s CWO, which holds the Vanguard MSCI Emerging Markets ETF (VWO). These ETFs are subject to the 15% withholding tax on foreign dividends. For more on this confusing but important tax rule, see this post by Canadian Capitalist.
- I assume the Canadian ETF provider does not incur any foreign exchange fees on its transactions, or when receiving dividends. (In reality this cost is not zero, but when I asked iShares about it, they explained that they get institutional rates which make it negligible — perhaps a basis point or two.)
- The MER of the US-listed fund is assumed to be 0.09%, while the cost of the Canadian ETF is 0.26%. (This is the actual cost difference between IVV and XSP. Again, you can easily change it if comparing two other ETFs.)
- Every year, I assume the funds earn a 7% total return, consisting of a 5% capital gain and a 2% dividend yield. This return is before deducting the fund’s MER and withholding taxes.
- Finally, I had to assume that the Canadian-listed ETF does not use currency hedging. In the real world, both XSP and XIN do hedge currency. (The Canadian version of the iShares MSCI Emerging Markets Index Fund (XEM) does not, however, so the assumption is not baseless.) Unfortunately, there’s no meaningful way to include currency fluctuations in an illustration like this one.
You can download the spreadsheet for all the details, but here are the highlights: the US-listed ETF doesn’t take the lead until year 7 with a lump sum contribution, and it takes 11 years to break even with the $5,000 annual contribution. In both cases, however, by the end of a 20- or 30-year period, the cost advantage of the US-listed fund is huge. The investor who made the $100,000 one-time purchase is almost $70,000 ahead after three decades.
There is a lot more to say on the topic of foreign equity ETFs, including suggestions on how you can dramatically lower that 1.5% currency exchange fee, and a look at whether the currency hedging in Canadian ETFs is really a good deal. We’ll look at both these issues later in the week.
Excellent analysis !
This study demonstrates that a Canadian investor needs to be super-careful about currency conversion fees when investing in foreign securities, otherwise only your brokerage is getting rich.
Very useful spredsheet! Thanks.
I also want to thank you for the ETF MER vs ME page you created back in February 2010. It would be great if you can update it once or twice a year when the MER’s become available.
Hard to argue with hard numbers !! Thanks !!
So after looking at this, why would I even bother with a Global Couch Potato portfolio in iShares? Or any other portfolio with Canadian ETFs holding something US/internationally backed? Assume over 20 years with $100k contribution.
@rmch: Currency hedging is the main argument in favour of XSP or XIN. There is also an argument in favour of Canadian-listed ETFs for investors with shorter time horizons, small accounts, or who can’t overcome large currency exchange fees. But if you are assuming a 20-year horizon and $100,000 in contributions and aren’t concerned about currency risk, then I agree: you shouldn’t use the Global Couch Potato. One of the other Model Portfolios would likely be a better choice.
While it doesn’t have anything to do with the cost benefit /analysis of Canadian and US ETF’s, US estate tax provisions should be taken into account by larger investors when making the investment decision to buy US rather than Canadian ETF’s. It may be that the cost savings of using US ETF’s are outweighed by the risk of US estate taxation of the US ETF’s.
Thanks. In re-reading this, how much difference would there be in changing this scenario to a non-registered account?
One way to use this spreadsheet comparison would be to decide between buying US-listed or Canadian-listed ETFs to gain portfolio exposure to US and international equity.
But a second way to use the results would be to decide whether it makes sense to be making such a large allocation to foreign securities in the first place, given the high costs of both options to Canadian investors.
The model portfolios discussed on this site all have a 30-50% allocation to US/international equity.
But I suspect that if we included all of these aforementioned costs (currency exchange fees, withholding tax…) in a mean-variance optimization, the results would indicate that we should buy very little of *EITHER* US-listed or Canadian-listed foreign-stock ETFs — and instead allocate a much larger portion of our portfolios to low-cost C$ investments in Canadian securities, like XIU.
@Wendy: While I accept that some investors do not want to hold 30% to 50% of their portfolios in foreign equity, I don’t think you can argue that the reason is cost. This is especially true in an RRSP, where the withholding tax is avoided. If you can keep currency conversion costs to a minimum (and I will have some ideas in my next post), then US-listed ETFs will almost always end up being extremely low cost.
CCP, I’m looking forward to your next post.
I’d be very interested to know just how much various Canadian investors are paying for currency exchange at the major Canadian discount brokerages. It seems like these firms do their best to make it difficult for even their own customers to figure out the substatial amounts that they’re being charged for CDN-USD and USD-CDN conversions.
I’m thinking specifically about CIBC Investor’s Edge, Credential Direct, Disnat, HSBC InvestDirect, Questrade, Qtrade Investor and Scotia iTrade.
There is a minor error in your spreadsheet. Column D should count foreign exchange conversions twice because dividends will be first converted to CAD and then converted back into USD for reinvestment. The difference isn’t much — about 1% but it narrows the gap between the US-listed ETF and Canadian ETF a little bit.
There is one potential benefit associated with investing is USD ETF. As of today, the USD is very cheap, historically it goes higher so invesdting in a USD ETF and wait until the USD is stronger can have a bonus
Am I missing something?
The assumptions for US equity ETFs look reasonable (as a first approximation) but wow do the numbers change when looking at US fixed income ETFs. The payback period on holding JNK or HYG (8% distribution yield) is around one year, even ignoring MER differences. This comes from the withholding tax drag.
@CC: Wouldn’t the double-conversion on dividends depend on how you were handling them? I’ve been looking into this stuff recently, and the TDW folks said that if you have the RRSP ETFs set up for dividend reinvestment DRIP:
“If you sign up for a DRIP on a US$ security, when the DRIP is executed – there will be no conversion back and forth to the Canadian Dollars and you will not be “double charged” the exchange rate. TD Waterhouse will hold your US$ dividends in US currency and purchase the stock using the same F/X rate – no US to CDN conversion will occur. If however, you didn’t have the DRIP enabled, you still have the option to call TD Waterhouse one day prior to the dividend payment and we will be happy to arrange the “Wash” of your US$ dividends into TDB166.”
The non-DRIP “wash” would seem to be a pain, so it would be nice if this could be set it up automatically or just hold $US in the RRSP account like RBC now has, but it does seem possible to avoid the double-exchange on dividends? And for a non-registered account, wouldn’t the dividends just go into the $US sub-account without conversion, or am I missing something?
@NortherRaven: I can confirm observing the DRIP behaviour. That is, a USD security will DRIP without converting to CDN first.
@Northern Raven: I wasn’t aware that setting up a synthetic DRiP avoids currency conversion fees. I was also not aware that you can wash US dividends into TDB166 by calling into TD Waterhouse. Essentially, what this means is that double conversion of dividends does depend on how you reinvest dividends and your broker. You could either pay nothing in conversion fees or pay conversion fees twice.
You’re right about taxable accounts. Dividend payments stay in US dollars. Dan’s example here deals with US-listed ETFs held in RRSP accounts.
Considering the tax on us-dividend, is using US ETF in a taxable account still the best solution ?
I confirmed with TDW rep that dividend can not be washed.
Interesting spreadsheet. Thanks for making it available. Playing with it, one realizes that the main factor influencing the long term end value difference is … not MER, not FX fees, rather it is the 15% withholding tax combined with the dividend yield! Try entering in the Lump Sum scenario: Currency conversion at 1.5% (i.e. high), US MER 0.75% (i.e. higher than Cdn MER), Cdn MER 0.66%, Div Yield 2%. The US ETF goes ahead by year 19. On the other hand, put 0% div yield and the Cdn ETF starts ahead and stays ahead. When Div Yield is anything up to about 1.5% Cdn US ETF wins because of the diminished effect of the 15% tax.
@CanadianInvestor: Thanks for stopping by. Based on a 2% yield, the withholding tax amounts to a cost of 0.3% a year. In many cases, the differences in MER between Canadian and US ETFs are more than that. But if the MERs are pretty close, or if the yield is particularly high, I can see how this might tip the balance.
The other factor to consider is that many Canadian ETFs that hold foreign stocks have higher tracking errors than their counterparts from Vanguard and other large US providers. In the end, that’s probably the biggest factor. It’s just impossible to account for it in the spreadsheet because it’s unpredictable.
All these works seem to be a bit pointless to someone who is paying 150 basis points for currency conversion. Time would probably be much better spent on researching ways to convert CAD to USD cheaply.
Also, I don’t know if anyone here has noticed, but some of the ETFs listed in Canada are actually ripoffs. One prominant example is XCH: its sole holding is its US counterpart FXI. So anyone who is holding XCH is paying double amount of fees.
Hello, I’m looking for a US equity ETF for my RRSP to start the US equity portion of my couch potato portfolio. I am in my late 20s, and will not be using this portion of the RRSP for the HBPs (already maxed). The intent of my US ETF, would be to remain in my RRSP until I retire. My initial contribution will be about 4k, followed by annual contributions.
I gave the spreadsheet a try (thanks for that) and the advantage still comes out at year 11. So, does this mean I should a Canadian based US Equity ETF first and once I reach year 11, switch it to the US based ETF?
@Maybelline: If you discovered that your break-even point is 11 years, that assumes that you start using the US-listed ETF now and hold it forever, As soon as you switch, you would need to start the comparison process again. I would suggest tat you consider some ways to reduce the currency conversion charges you’ll face when purchasing the US-listed ETF. I’m sure you can reduce that period to much less than 11 years:
https://canadiancouchpotato.com/2010/10/19/reducing-the-cost-of-currency-exchange/
https://canadiancouchpotato.com/2010/11/12/lowering-your-currency-exchange-fees/
Thanks so much for your quick response. Your articles are very informative!
I have been playing with the spreadsheet to use it to compare US listed ETF’s to US equity index mutual funds (i.e. the Cdn big bank low MER US Equity ETFs such as TD e-series). If the latter were held in an RRSP there would be no 15% withholding tax, correct? (unlike the Canadian listed US equity ETF option that you built the spreadsheet with). When I also add in the consideration that a US listed ETF cannot be drip’d, at least not in a Qtrade RRSP, it appears that the index MF fund compares well with the US ETF option, mostly because all the dividends are reinvested (you’d have to pay commissions to reinvest the US ETF dividends) and there’s no loss to the 15% withholding tax?
Potato mentions that tracking error might overwhelm the other factors anyway. I did my own spreadsheet and found that indeed to be the case when tracking error gets to about a 1% difference between the Cdn-based ETF (assumed to be and in fact, almost always higher) . An investor can choose between Cdn vs US ETFs that do not merely hold the other inside where tracking error must be compared e.g. PRF vs CLU.C. International (non-US) equity ETFs must contend with international withholding taxes on top of US withholding taxes (yes, the USA shamelessly applies its own tax on foreign non-US dividends, already dinged by UK, Korean, Australian etc withholding taxes, that are merely passing through the USA on the way to Canadian investors who then get taxed by Canada as well) e.g. emerging markets XIN holds EFA holds emerg mkt equity vs CIE holds emerg equity directly. I also built in what happens in different account types (RESP, TFSA, taxable) and found that influences outcomes a lot depending on the dividend/distribution yield (obviously, the higher the distrib, the more the 15% withholding tax matters). My conclusion is that one must carefully combine multiple considerations for best results: holding account (RRSP, TFSA, taxable), ETF type (direct vs ETF-inside), ETF trading country (US vs Canada), ETF tracking error (which includes MER and other sources of performance drag, esp. poor hedging) and have good assumptions about distribution yield vs capital gains return in future.
@Karen: When a Canadian mutual fund holds US securities, and you hold the mutual in an RRSP, you still pay the withholding tax on dividends. This is because, technically, the mutual fund holds the stocks, not you. And therefore the mutual fund is subject to the withholding tax. The only way to protect yourself from these withholding taxes is to hold the US securities directly.
While it is true that you need to pay commissions to reinvest the distributions paid by US-listed ETFs, this is pretty small issue for most investors. In most cases, you will be adding some new money to the account each year anyway, and you should be rebalancing once a year or so. So you can just add the accumulated cash to these purchases without incurring any more trading cost than you would have anyway.
While US-listed ETF may have lower MER, I am not sure they are a good idea inside a taxable account for different reasons:
– Loss of the foreign dividend tax credit
– Risk of US estate taxation
– loss of capital gain distributions’s preferred tax treatment, which will be taxed as regular income if you use a US-listed ETF .
Here is an interesting article on the subject by Jamie Golombek http://www.advisor.ca/tax/tax-news/taxing-foreign-dividends-2459
For these reasons, I’m not sure that “The Complete Couch Potato” model portfolio would be a good fit inside a taxable account. What do you think?
@Jas: First let me be absolutely clear that I am not a tax expert and I may well be wrong about this, so no one should act on anything I say without checking with an account first. End of disclaimer.
– There is no “foreign dividend tax credit.” Dividends from foreign stocks are fully taxable as income. However, as I understand it, withholding tax on dividends from US-listed ETFs (typically 15%) may be recoverable with the federal foreign tax credit:
http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/ddctns/lns409-485/405-eng.html
– There is a risk of US estate taxes, but currently that risk applies only to people with a good deal of wealth in US assets:
https://canadiancouchpotato.com/2011/12/08/ask-the-spud-am-i-vulnerable-to-us-estate-taxes/
– The treatment of distributed capital gains as income is news to me. I have never heard this mentioned in relation to US-listed ETFs before, but I will try to look into it. In the meantime, as always, get professional advice before making any investment decisions for tax reasons.
@Couchpotato
It was my mistake, I was talking about the federal foreign tax credit to recover withholding tax for foreign dividends. I’m don’t think you can claim the credit with US-listed ETF, as well as with “pseudo” canadian ETFs that invest in US etfs (like XWD).
See this post on the subject: http://www.financialwebring.org/forum/viewtopic.php?f=32&t=114375&p=451211&hilit=taxation+foreign+etf#p451211
Here is an email from Ishare taken from the post above: “Our wrapped products such as XEM, XSP, XIN and XWD are subjected to 15% US withholding taxes. Investors in these ETFs will see a credit on their T3 tax slip on a annual basis. This is assuming that clients are holding these securities in a taxable investment account. However, the only tax credit clients will receive are for the amounts withheld by the US, as the tax treaty is between Canada and the U.S. So even though funds such as XEM hold securities of other countries, the taxes that are withheld between the US and other countries is not claimable (no tax credit).”
In summary, there is increased withholding taxes as there is double withholding taxes on US based international ETF but with only one recapture…this will adds an additional 20 to 30 points drag on those ETFs according to an advisor I contacted.
Unfortunately, there are not many options for those looking for “canadian domiciled” international and US index funds… there a few mutual fund companies (mainly TD e series) but none of the international ETFs recommended on your site are truly “canadian domiciled”
@Jas: Thanks for the link. Note that the email from iShares does not pertain to ETFs holding US equities, only overseas equities, so we shouldn’t include VTI as part of the discussion.
At the end of the day, international equities are always going to face some drag from taxes in a non-registered account, but as you point out, there really are not a lot of truly Canadian-domiciled choices. I would rather pay 18 basis points for the diversification and convenience of VXUS and incur a small tax drag than pay 70 or 80 basis points for a Canadian fund that was slightly more tax-efficient, especially if that Canadian fund also used currency hedging.
@CCP: It is true that that even if holding VXUS has tax drag costing has much as 40-45 basis points , it might still be the best option if in Canada if one wants a low cost unhedged international ETF…
I found a new article written by Justin Bender at PWL capital that explains quite nicely the withholding tax problem with foreign ETFs:
Foreign Withholding Taxes – PWL Capital
https://www.pwlcapital.com/pwl/media/pwl-media/PDF-files/Justin Bender Assets/Foreign_Withholding_Taxes.pdf
The link above doesn’t work, so I put the article on my public dropbox account for your readers:
http://dl.dropbox.com/u/3321363/Foreign_Withholding_Taxes.pdf
Correction: the article was in Justin Bender’s folder on the PWL site, but it is written by Dimensional fund advisors
Also, if you invest in US listed ETFs, don’t forget to fill out the W8-BEN form, because otherwise you’ll pay a 30% withholding tax on dividends instead of 15%. I have a friend who just found out that his discount broker didnt submit the form for him…
“3. Dividends from U.S. stocks will be subject to a 15 per cent withholding tax if held in a non-registered account, as long as you have submitted a W8-BEN form to indicate that you are a Canadian resident. Otherwise, the withholding tax rate will be 30 per cent. Many brokerages submit the W8-BEN form for their customers but some customers do “slip through the cracks,” observes Ram Balakrishnan, author of the Canadian Capitalist blog.”
http://v1.theglobeandmail.com/partners/free/globeinvestor/investment/may08/online/tax.html
Dan,
I am considering two etfs for my us part of portfolio in RRSP account:
1. CUD vs SDY: CUD MER is 0.66%
2. VUS vs VTI: VUS MER is 0.15%
both CUD and VUS are hedged. 50%-50% in each, about $75000 total, lump sum. The issue I am concerned about are the currency exchange fee on initial and on dividends. Would you recommend I hold VUS and CUD or VUS and SDY or both US versions.
For international: I am considering VXUS, I would probably have to hold in non-reg, I think I can use the suggestions to reduce the currency fee.
Thanks
Onkar
Hi Dan,
Thanks for the great post and calculator! I am new to the couch potato strategy (and have been reading your blog heavily). I was initially leaning toward using purely Canadian ETFs for my total portfolio but after this post, I have 2 questions:
1) it seems that if we have a 20+ year horizon, we are better off to use US listed ETF’s in the RRSP rather than a Canadian one even if the MER’s are closer together (ex. XUU 0.07 vs ITOT 0.03)? This is assuming a 1.5% conversion. This calculator also doesn’t take into account Norbert’s Gambit, which would help lean toward the US listed funds even more?
2) In another post on reducing exchange fees- did you mean Questrade only charges 0.5% for US transactions (not 1.5%)? Wasn’t able to find this on their site.. This would again be even more in favour of US listed funds.
I realize this is an older post, but I believe the principles still apply. Thanks again!
@Arjun: There’s no question that US-listed funds would be cheaper in an RRSP over the very long term. The question is whether you feel the savings are worth it given the extra effort involved. Remember that you would need to convert currency every time you add money or rebalance: It’s not just one transaction and then 20 years of zero effort. Since this post was written I have come to see that most DIY investors should just use Canadian-listed ETFs for simplicity. especially in small portfolios.
Regarding Questrade’s FX rates, they say their target spread is 2%, which is dreadful:
https://www.questrade.com/pricing/self-directed-commissions-plans-fees/forex-cfd
Let’s say in 5-10 years you want to sell part of an US listed ETF’s (RRSP), and need to withdraw the money from your account, will the bank convert it automatically from US to CAD? and apply a 1.5% conversion rate? or can you withdraw the money in US dollars? and convert it yourself?
thanks!
@Erika: If you have a USD bank account, you should be able to make the RRSP/RRIF withdrawal in US dollars without the forced conversion.
Thanks for the quick answer!
Regarding your above answer, I have another question that maybe it won’t make sense to you, but I will ask it anyway (pls note I am quite new to DYI investing):
If you want to buy US listed ETFs, can’t you just open an USD account at your Canadian Bank, and have your RRSP linked to this account for the US portion of your portfolio?
My second question: if I want to use the Norbert’s Gambit to convert CAD to USD in order to buy US listed ETF in my RRSP, for example VTI, above what amount is it worth it? above 50,000CAD or maybe 100,000CAD?
and what would be a good strategy, to invest in CAD listed ETF until you reach that amount and after to switch to US listed ETFs?
@Erika: To buy ETFs in US dollars in an RRSP, you need to have a US-dollar RRSP account: it’s not enough to simply have a US-dollar bank account.
As for when it makes sense to use US-listed ETFs, I’d suggest you are in the right ballpark with your range of $50K to $100K. The approximate cost savings from withholding taxes is about 0.30%, which is $30 annually for every $10,000 invested. And remember that Norbert’s gambit involves some additional trades that will reduce that savings. So it’s only when you get into the high five figures (at least) before there’s a very compelling reason to use US-listed funds.