In an era when ETFs are becoming increasingly narrow and specialized, the new iShares funds launched this week were a pleasant surprise.
Granted, they were late to the game with the iShares S&P 500 (XUS), which is now the fourth ETF that tracks the S&P 500 with no currency hedging. (Vanguard, BMO and Horizons all beat them to market.) But the two international equity ETFs are a lot more interesting. In fact, the iShares MSCI EAFE IMI (XEF) and the iShares MSCI Emerging Markets IMI (XEC) are the most significant index funds to be launched in Canada in at least six months.
We are the 99%
The “IMI” in the name of the international funds stands for Investable Market Index. These MSCI benchmarks are designed to capture 99% of the equity market in a given region, including large, mid, and small cap companies. This is the same strategy used by the Vanguard Total International Stock (VXUS), a core holding in my Complete Couch Potato portfolio.
All three of the new funds simply hold an existing US-listed ETF in the iShares Core Series, launched last October. iShares describes the Core Series as “a competitively priced, diversified, tax-efficient family of ETFs that investors can use as building blocks for the heart of their portfolios.” In other words, no fringe asset classes or clever strategies: just plain vanilla, total-market index funds. The Core Series was a response to earlier price cuts by Vanguard and Charles Schwab: with expense ratios between 0.07% to 0.18%, they are the cheapest iShares products in the US.
When you combine broad diversification and rock-bottom costs you get exactly the kind of index fund you should look for when assembling a long-term portfolio. That’s what makes these new ETFs so appealing.
Best in class
Let’s start with the iShares MSCI EAFE IMI (XEF), which is notable for at least three reasons. First, the index includes more than 2,500 companies in Europe, Australasia and the Far East, compared with 950 or so in a conventional EAFE index fund. Next, its management fee of 0.30% is the lowest in its class. Finally—and most important—it does not use currency hedging, which makes it almost unique in Canada.
Meanwhile, the iShares MSCI Emerging Markets IMI (XEC) includes over 1,600 companies, primarily based in China, Korea, Brazil and Taiwan. That’s about twice as many stocks as the older iShares MSCI Emerging Markets (XEM), and with a management fee of just 0.35% the new ETF is also half the cost. Indeed, it’s even cheaper than the Vanguard FTSE Emerging Markets (VEE).
It seems clear that these are now the best international equity ETFs in Canada. Readers who don’t want to use US-listed ETFs often ask me for an alternative to VXUS, but until now there wasn’t anything remotely like it. Now you can combine these new iShares funds to get close. Emerging markets make up about 20% of VXUS, so in theory you should hold about four times more XEF than XEC. In practice, if you’re using the Complete Couch Potato, you may want to simply go with 10% XEF and 5% XEC instead of 15% VXUS. Remember, asset allocation isn’t an exact science.
iShares Canada is certainly feeling the competition these days: its market share is still over 70%, but BMO is closing the gap, and Vanguard is finally starting to gain traction. That was likely the motivation for these new ETFs. Instead of launching more and more narrow products, iShares looks ready to take back some assets by targeting buy-and-hold investors. Good on them for making that decision.
K. I cashed my funds out a year ago and market gone straight up. Sitting on 6 figs in cash and would like to ease in cheaply. Any dollar cost averaging products?
@Jas, I’ve owned VEA for years unregistered and it remains my choice along with other similar US listed ETFs(SCHF, IEFA, etc).
Next from your list would be TDB911 and finally XEF but these last 2 are a close decision. The lost foreign non-US taxes in XEF are likely to negate the MER advantage and perhaps even more. Once you factor in commissions, bid/ask spreads, etc I’d opt for e-series.
Hopefully we can get better truly Canadian low cost EAFE choices in the next 5-10 years before some of us start running into US estate tax territory.
Great post Dan. It’s great to see a strong alternative for the VXUS.
What are your thoughts between the XUS, VFV and ZSP? I know they are very similar, but I see you have listed the XUS with the lowest mer in your recommended etfs?
@Edwin: I’ve listed all three in my list. They are all virtually identical and I can’t think of a good reason to favour one over the others. A difference of one or two basis points in MER is meaningless.
@Dan – Thanks for your input. Keep up the great work on your blog!
Thanks for the review, I do find it very useful. Your web site offers quite a bit of sound advices on how to build a robust index / ETF portfolio, and I find that the material presented complements nicely readings on the matter. I find that there is sufficient evidences to go ahead and make the switch from the traditional active investing approach with mutual funds to an index / ETF passive investing approach. Following your advices, it is relatively straightforward to either adopt or tailor one of your portfolios. When switching large sums that way though (ie. say $ 150 K +) from active to passive investing, one is confronted with the best approach to do so in a prudent and progressive manner. It is that much more so enerving, given the weight of bonds to equity in any portfolio and the great deal of uncertainties where the bond market is really heading. Any thoughts you wish to share with the readership on the matter, ie. suggestions for prudent/progressive approaches to re-invest proceeds from mutual funds to into an index / ETF portfolio ?
Best regards and thanks again for you website, I enjoy reading it.
@Serge: The model portfolios are examples only, and you are welcome to lower the bond allocation if that is appropriate for your situation. Once you have an appropriate asset allocation in mind, selling your existing mutual funds and building a new ETF portfolio is straightforward. This post may help:
This news might mean the end of XWD. For a time, XWD was the only way to get unhedged Canadian listed ETF exposure to the US and EAFE markets. With the new ETFs, you can get such exposure at lower costs; it’s also more tax efficient, as Canadian stocks are about 4% of XWD. The dividends on those Canadian stocks were taxed as foreign dividends with loss of foreign tax credits.
If XWD ends, there will be capital gains taxes to pay.
@Park: That’s exactly what I was thinking. I currently hold XWD in a registered account and I’m thinking about liquidating it to buy XUS/XEF/XEC. Thoughts?
@Park and Rick: There are two good reasons to switch from XWD: lower fees and broader diversification. Just remember that you’ll now have three funds to buy and rebalance rather than one, which will raise your transaction costs.
Fear that XWD will be shut down is misplaced. iShares has almost never closed an ETF in the 14 or so years they have been in Canada.
As for the loss the tax credits on Canadian dividends, now we’re talking about fractions of a basis point, and the cost of one trade will almost surely wipe this out.
Always consider the big picture and do the math before switching.
@CCP: Thanks for replying! I’m a big fan of your blog and often recommend it to my friends and family. Cheers.
“As for the loss the tax credits on Canadian dividends, now we’re talking about fractions of a basis point, and the cost of one trade will almost surely wipe this out”
These wrap ETFs of US listed ETFs have tax inefficiency, the above comment being one example. There are those who would say that the loss due to the tax inefficiency is small. My counter to that is that based on present valuations, stock returns after inflation/taxes/expenses are going to be modest in the future. In that setting, you want as much in your favor as possible.
In comparing foreign withholding taxation/recovery of VXUS vs XEF+XEC, is it fair to say that a Canadian investor in a taxable account should not see much of a difference. I refer to the excellent post below, but just wanted to make sure I understood correctly. If true, is the only difference between these two is currency conversion, MER and exposure to US estate tax liability?
@sleepydoc: You’re correct. The only tax advantage of VXUS would be in an RRSP.
I picked up 55 units of XEF @ 18.80. I should have grabbed more.
I missed Rick’s comment about XWD. IMO, if there are not significant capital gains tax to pay on selling XWD, I would.
Thanks for the post. Given the double withholding tax problem, what is the best way to get international equity exposure within a TFSA? It seems as though XEF is a bad choice, but direct ownership of IEFA is no better. Are there any Canadian-based international equity ETFs that do not involve a U.S. entity?
@Jonathan: The best you can do is use a Canadian-domiciled fund that holds the international stocks directly so you only pay one level of withholding tax. Unfortunately, Canadian-domiciled ETFs that hold international stocks directly are rare, and the ones that do exist are expensive.
That’s what I was afraid of – is there a specific example you know? I wonder if one is better off paying the higher fee or accepting double taxation of dividends..
@Jonathan: The two that come to mind are ZDM (from BMO) and CIE (iShares).
In my humble opinion if you bought XEF for the dividend income you may be overlooking growth potential.
How does this post affect the decision of an incorporated professional who wants international index etf non hedged in their corporation investment account?
It would be great to have a table that compares these funds, vxus, xec +xem, cie, zdm mers with year end net taxable amounts and whether distributions as roc, interest income in this context.
I meant to say XEC + XEF in above posting
I have VXUS in my RRSP and I’ve been happy with it. But I’m not keen to convert yet more Cdn $ into US $ so I was interested to learn more about XEF. It may well be the best international ETF on the market for growth potential, but I wonder Dan, when you’re declaring that it might now be the best, whether you’re discounting the large difference in yield for these two ETFs.
The dividend yield for XEF stands at 2% while VXUS comes in at 5.05%
To me that’s a substantial difference and tips the scale to VXUS. It might not were I holding the security outside my RRSP, because of withholding tax. But since it’s in the RRSP I believe I’m largely (or completely) protected from that. So I’m not sure I’d choose XEF over VXUS in that situation.
@Trevor: There are two issues to address here. First, your info on the yield of these two ETFs is inaccurate. According to VXUS’s web page, its current yield is just over 3%. XEF, meanwhile, is so new it has made just one distribution, so the yield on the iShares website is just a guesstimate with one data point. A more reliable figure comes from IEFA, its underlying holding. The yield on that fund is 2.5%. So there is a difference, but it’s small.
The second issue is the assumption that an ETF with a higher yield is superior. You still pay the international (non-US) withholding tax when you hold VXUS in a registered account. There is no way to avoid this. So all other things being equal, you should prefer an ETF with a lower yield.
In the case of XEF, you are also paying the US withholding taxes, so the other factors are not actually equal, but the point is that there’s often good reason to prefer lower-yielding international ETFs, because the dividends are subject to more tax than capital gains.
So if I hold XEF/XEC in my unregistered account – because they are “wraps/shells” of an existing US ETF, will the withholding tax be unrecoverable?
I know that if I were to hold the US ETF directly in my unregistered account, the withholding tax would be recoverable, but from I understand, this extra layer of ETF removes that benefit. Is my understanding correct?
@Frank: In a non-registered account, the US portion of the withholding tax is recoverable, but the international portion is not. Full explanation here:
Thanks Dan. I took the yield information for each of them from the Royal Bank’s RBC Direct Investing site. Now I’m curious why their information is so out of whack.
And thanks for the insight into withholding tax. I clearly have to look into that further.
@Trevor: In my experience, almost all third-party services have wildly inaccurate yield info for ETFs. I’m not sure why that is, but I always go to the ETF provider’s website to get these numbers.
The links I provided for Frank above explain the details of foreign withholding taxes. Hope they help.
Thank for that information Dan. Just to confirm what I’ve read and heard about since it’s a bit tricky – if I were to hold the new unhedged version of VUS in my RRSP (which holds VTI inside it), is it correct to say that the withholding tax is both applied AND unrecoverable?
Also, according to the links you provided, it also seems that XEF and XEC are both pretty tax-inefficient (you recommended avoiding them in both non-reg and RRSP accounts). In your opinion, are they still worth getting despite this tax inefficiency? (versus holding a US ETF that holds the foreign equity directly)
Thanks very much for your time!
Another question that came to mind – since XEF and XEC hold the US-listed iShares core holdings, is there an added level of taxation from the US ETFs?
For example, with XEF, would the ISHARES CORE MSCI EAFE ETF pass on it’s MER to XEF, and then XEF accounts for both that MER and it’s own, in essence double charging the MER fees on both funds, to the shareholders?
This seems too brutal to be true, so I imagine iShares waives the iShares Core fees, but I thought I’d double check.
One more question – I’ve always read about the withholding taxes being recoverable but never questioned how this works. Is this an automatic dividend tax credit thing or do I have to actively fill out forms and/or apply for it? And is it a complete recoverable or just a portion?
Thanks again for everyone’s input, you guys are most helpful!
@Frank: I’ll try to answer all of your questions here:
1. “If I were to hold the new unhedged version of VUS in my RRSP (which holds VTI inside it), is it correct to say that the withholding tax is both applied AND unrecoverable?” Yes, that’s correct.
2. “In your opinion, are XEF and XEC still worth getting despite this tax inefficiency? (versus holding a US ETF that holds the foreign equity directly).” You need to weigh the tax inefficiency against the benefit of being able to trade the ETF in Canadian dollars. If you are able to exchange currency cheaply, then something like VXUS is clearly preferable. But exchanging currency can be extremely costly for many investors.
3. “Since XEF and XEC hold the US-listed iShares core holdings, is there an added level of taxation from the US ETFs?” This question is confusing because you go on to talk about MERs, not taxation. Yes, there is extra layer of withholding tax, but no, the MERs are not doubled up. The MER of the Canadian ETF includes the one charged by the underlying ETF.
4. “I’ve always read about the withholding taxes being recoverable but never questioned how this works?” It is not automatic. You need to claim the foreign tax credit on your annual return. The amount you can claim will be itemized on the T-slips you receive from the fund company each year. It should be completely recoverable.
When considering emerging markets in asset allocation, how worried should we be regarding corruption and manipulation of those markets? Though there is increased volatility, is there an equal degree of compensation?
@Jon: It’s a good question, and certainly there are some experts who advise against any allocation to emerging markets at all. I don’t think that’s an unreasonable position. But personally I feel the broad diversification in an emerging markets index fund (often 900+ companies in over 20 countries) alleviates most of the concerns: corruption in Brazil, say, isn’t going to have much affect on the Chinese or Korean holdings.
As for being rewarded with higher returns, yes, there is good evidence of this. The MSCI Emerging Markets Index returned about 11.5% annually from 1988 through 2102 (in Canadian dollars). Canadian stocks returned about 8.3% over the same period.
I guess I’m still not getting the nuances of the foreign withholding tax issue. In the end, is vxus still the clear winner for an international equities portion of an rrsp. Is there a canadian listed fund that is just as tax efficient in an rrsp?
@Ben: The key point is that there is no way to avoid international (non-US) withholding taxes in an RRSP, no matter what type of fund structure you use. The only factor you can control is whether you will also have to pay a layer of US withholding taxes.
A US-listed ETF like VXUS is the most tax-efficient choice. The second best (from a tax point of view) is a Canadian-domiciled ETF or mutual fund that holds international stocks directly, but there are very few of these. ZDM and the TD International Index are the best examples. The most tax-inefficient structure in an RRSP is a Canadian ETF that holds a US-listed ETF of international stocks, such as XEF or XEC. In this latter case, you will have to pay two levels of withholding tax.
Would you recommend ZDM considering its tax advandage despite the fact it offers currency hedging?
@Jas: No, I would rather pay the withholding tax than pay for currency hedging.
I’m a rookie here and tried Norbert’s gambit with Royal Bank stock on the TSX a few days ago in order to gather some US funds to buy VWO, VEA and VTI for my RSP. Confused by the “part-filled” message on the Direct Investing site, I waited too long, so I didn’t make the switch on the NYSE. Now I’m down $2/share on the TSX, waiting for the stock to rise before attempting to sell it on the NYSE.
But given the dropping loonie, is it worth it just to buy the US ETFs? Or should I stick with the TSX versions for my RSP?
@Rob: You’ve discovered the risk of using Norbert’s gambit with a stock rather than DLR/DLR.U. The spread is smaller, but it does introduce market risk if for some reason you’re not able to execute both trades quickly.
Regarding the dropping loonie, that has no effect on the decision between US-listed and TSX-listed ETFs:
I have a relatively small holding of VXUS in my TFSA and intend to sell it and reinvest the proceeds and this year’s TFSA contribution in XEF. I’ve noticed that the spread between VXUS and XEF varies considerably. If the two funds were perfect substitutes, one would expect that the exchange rate would be the only driver of the spread variability. How does one assess how much of the spread reflects currency variation, and what other factors are in play?
@Celeste: VXUS and XEF both track international equities, but they are in no way “perfect substitutes.” VXUS includes developed and emerging markets, while XEF is only developed markets only, so their returns will differ significantly. They are completely different funds from different providers, so their relative prices have no meaningful relationship.
@Rob: I echo CCP’s comment. For other beginners out there, if you’re going to use a stock rather than DLR/DLR.U (and there are very good justifications regarding the savings to be gained if you are converting large amounts) then you need to be aware of the necessity for rapidity in executing your 2 sequential transactions. As a newbie, the unknown factor was very intimidating for me initially last year, but detailed research paid huge dividends. Every investor will be dictated by individual circumstances; in my case I was constrained by my reluctance to leave the trading platform used by my professional association (to go to RBC Direct, say), and the general reluctance of my association’s representative to comply with the requirements for an efficient Norbert’s Gambit (execution, followed by rapid journalling the stock to the other currency then selling on the other currency).
In the end I was able to negotiate a one-time only NG by going in person to my representative’s office while he talked directly with the broker on the phone as we jointly transacted a large conversion of US dollars to CAD by splitting the amount into 4 smaller portions, and doing serial purchases in USD on the NYSE and rapid sales in CAD on the TSE of TD which was the most efficient stock at the time (I see that TD has since split its stock, and so Royal Bank is more efficient now).
It was a huge undertaking in research and logistics for me, but worth it, as I saved thousands of dollars (compared to even the quite economical easier DLR method). My point is that Norbert’s Gambit is now very well documented (in this Couch Potato site as well as elsewhere)
and as long as you are prepared to do your homework, and perhaps (especially if you have never done it before) even to do a small practice purchase/sell dry run (which will cost you only a few dollars, but will drastically reduce the chance of a transaction delay due to inexperience), is well within the capability of a prepared and rehearsed newbie.
In comparing VXUS to XEF and XEC, I see VXUS has about 22 percent invested in Eurozone……..how do we know what percentage is invested in the many(I think 18) countries that is comprised of the Eurozone. It is fine to say VXUS has 22 percent of index in Eurozone but what if 20 percent of that is in Portugal…..there broke aren’t they………I am being silly but you get the point, how can we find out about actual percent invested in each country?
@mark: You can see the country breakdown on each ETF’s website:
Awesome, thank you.