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.
Cool, thanks again for posting new arrivals like this. I try to read around every now and then, but I frequently don’t see press releases when new funds are issued like this, so it’s nice know I can find them here.
These look like great products, especially XEF without hedging – finally! I know that for some ETF launches you sometimes recommend waiting a while before jumping in, but since these are just TSE-listed containers for US-listed ETFs (which I presume are fairly large and liquid), do you recommend any waiting period at all?
@Danno: I don’t see any issue with using these ETFs immediately if they suit your needs. The underlying ETFs already have hundreds of millions in assets, so they’re not going anywhere soon. As always, it’s often best to just wait until you were going to rebalance or add new money anyway, but I’ve already added these to my list of Recommended ETFs.
Welcome news for a Monday morning. Thanks for the post, Dan. This’d be the first time I’ve invested in so-called funds of funds. One thing that isn’t clear to me is how dividends from these funds are treated in terms of currency exchange costs and withholding taxes. Do dividends (in general) get hit twice with currency exchange costs: once when converted from an underlying company’s home currency to USD and again when converted from USD to CAD before landing in my account? I appreciate that this will occur behind the scenes, but I am wondering whether or not these costs are negligible. Secondly, how about withholding taxes on dividends? Because these funds hold US ETFs, are dividends subject to the 15% tax?
Why use these new Canadian-listed ETFs when one can simply buy the US-listed ones with lower expense ratios? Is it simply to reduce currency exposure?
I’m sure you have discussed this before, but you mention “Readers who don’t want to use US-listed ETFs…”. Are there particular circumstances where this would be the case? I could only think of two myself, either my RRSP or TFSA account doesn’t allow US-listed stocks or I am paying a lot for currency exchange.
@Cheapskater: There will be some drag caused by currency conversion but this is likely to be very small (funds don’t pay the retail spreads you and I do). As for withholding taxes, this is a complicated topic I’ve written about before. These “ETFs of ETFs” are quite tax-inefficient, but you need to weigh that against the potentially significant cost of trading US-dollar denominated ETFs.
https://canadiancouchpotato.com/2012/09/17/foreign-withholding-tax-explained/
@James: There’s no issue with currency exposure. When you hold a US-listed ETF of international stocks you have no exposure to the US dollar. This idea is often misunderstood:
https://canadiancouchpotato.com/2011/04/04/currency-hedging-in-international-funds/
https://canadiancouchpotato.com/2011/04/07/a-case-study-in-currencies/
@Bob: Those are exactly the reasons. The currency spreads charged by brokerages are a significant barrier to buying US-listed ETFs.
https://canadiancouchpotato.com/2012/12/17/how-much-are-you-paying-for-us-dollars/
Great news. Eventually I’d like to have my investments held in Canada rather than the US. I just keep having this niggling feeling that the US could interfere with tax treaties and the like at any time, and would rather hold my money on this side of the border. It’s a great option with iShares now for future rebalancing.
Good news for future buys! The way I read this, it makes sense to maintain extant holdings in VWO and VEA, though. Converting these now into XEC and XEF would generate trading fees and FX costs for no good reason, wouldn’t it?
This a good news for Canadian investors who don’t want to deal with the hassle of buying US-listed ETFs (currency conversion, more complicated ACB tracking, US estate tax, etc)
Unfortunately, it still doesn’t solve the problem of double levels of withholding taxes (with only one level recoverable) for international equities held inside a “pseudo-canadian” ETF investing in a US listed ETF. There is still no ETF alternative to TD e series international fund if one wants a real canadian ETF investing directly in international equities.
https://canadiancouchpotato.com/2012/09/17/foreign-withholding-tax-explained/
https://canadiancouchpotato.com/wp-content/uploads/2012/09/DFA-Foreign-Withholding-Taxes.pdf
HI Dan
Would these 2 be comparable to ZDM?
@Holger: I can’t think of a good reason to sell any existing holdings, especially of you would realize a capital gain by doing so. The US-listed version still have some advantages: the problem is they’re expensive to acquire.
@Ed: ZDM holds only about 300 large-cap stocks in developed countries, plus it uses currency hedging. These new funds are a dramatic improvement.
Do you recommend integrating any of these products into ‘The Global Couch Potato’ portfolio?
@CD: I’m not one to make changes to the model portfolios every time a new fund comes out, and VXUS is still superior for now, as long as you don’t get gouged on the currency conversion. But definitely something to keep an eye on.
Hello Dan,
When you say “you may want to simply go with 10% XEC and 5% XEM instead of 15% VXUS”, aren’t XEC and XEM virtually the same index (emerging market)?
@André: Sorry, that was a typo, which is now fixed.
Hey CCP,
Hoping you or some other fellow readers can help finalize my investment strategy. For the most part, I’m happy with the allocation placements and percentages of my portfolio. This article made me question which etf’s to hold and with hedging or not.
Currently, I own 20%xbb, 25%xsp, 20%xiu, 15%vef, 10%xpf, 10%xre. Held in tfsa’s and a joint margin. No RRSP’s.
I’m inclined to change vef(15%) to xef(10%) and xec(5%)?
Selling/buying will not incur significant tax issues for me. I buy etf’s commission free.
I know that there are too many articles already relating to xsp vs…and which account…high tax bracket/low bracket etc…foreign withholding rebate… so, even though I just went there, I won’t go there.
All/any insights and opinions are appreciated.
@Willy: I can’t offer portfolio suggestions to individuals: the ETFs in my model portfolios are the ones I generally recommend.
Didn’t think about that, sorry. Thanks anyways and always happy to see new articles.
These net ETFs are a great improvement, but I still would like to overcome the extra taxation associated with Canadian wrap funds of US located ETFs.
http://www.financialwebring.org/forum/viewtopic.php?f=38&t=115256&p=475999#p475999
“As do US stocks and ETFs that pay dividends/distributions to Canadian residents. However these 1099 forms show only the gross amounts of dividends/distributions and the amount withheld. They don’t break out the distributions by type, e.g. interest, dividend, capital gain. Under Canadian tax law all of this is considered interest income in any case.
As I understand it, CRA would be open to distinguishing between interest and CG distributions if the issuing security sponsor, Vanguard in your example, supplied them with annual returns and accounting that conformed with CRA rather than IRS tax reporting/accounting rules.”
In other words, it looks like if iShares and Vanguard provided the necessary information according to CRA rules, then the wrap ETFs might be able to increase their tax efficiency.
There would be a cost associated with providing the necessary information, which would increase the MER. But at least for ETFs with large asset bases, I wouldn’t be surprised if the increased MER was outweighed by the increased tax efficiency. For example, XIN has about $750 million in assets. The ETF providers might make the case that the cost is prohibitive. But TD eseries does this, and it costs more to run a mutual fund than an ETF.
Perhaps it is not possible for these wrap funds to be truly tax efficient. But I’ve never heard iShares or Vanguard say it wasn’t possible.
If more Canadian investors are aware of this issue and act accordingly, maybe things will change.
An addendum to my previous post…
For those who say that things can’t change, please remember the for years, we were told that those who bought Canadian domiciled ETFs that invested in foreign stocks wanted currency hedging. Because if they didn’t, they would buy the cheaper US listed ETFs. But due at least in part to Canadian bloggers (Canadian Capitalist comes to mind), we now have Canadian domiciled ETFs that invest in foreign stocks without currency hedging.
With just one more addition to my wish list (other exception is above), I would be a happy Canadian indexer. Why hasn’t one of the ETF providers provided an ETF that covers more of the US market than the S&P500 and is not currency hedged? For such an ETF held outside a TFSA, one wouldn’t have to worry about tax inefficiency. And if total market index ETFs can be provided for EAFE and emerging markets, why not the US market?
I am not sure but if you drip these does that not help avoid the 15% witholding on a dividend? Great news on these new ones on the block.
I have some ZLU.TO in my portfolio and will be adding these as well. I had planned on buying VXUS soon but will go with these instead.
@Park:
Thank you pointing out another important fact about US-listed ETFs.
Inside taxable accounts, US-listed ETFs and pseudo-canadian ETF investing in US ETFs are both much less optimal than a real canadian ETF investing directly into international equities for these two reasons:
1) Double levels of withholding taxes but only one is recoverable
2) All the distributions are treated as income, so you lose the tax advantage of capital gains distributions.
Another article on the subject of US mutual funds, which seems to apply to US-listed and pseudo-canadian ETFs as well:
http://www.advisor.ca/tax/tax-news/taxing-foreign-dividends-2459
@Park and Jas: Let’s try to remember that choosing investment product always involves trade-offs and it’s important to properly weight the pros and cons.
The lower MER on the US-listed funds is obvious: it’s about 15 or 20 basis points in the case of XEF and XEC. The double withholding tax on Canadian-listed international equity ETFs in RRSPs has also been well discussed, and it might cost you another 30 to 45 basis points a year. That’s certainly significant.
Both of these costs, however, must be weighed against the expense of trading in US dollars. If you have US dollars to invest, then US-listed ETFs are a no-brainer. If you don’t, you need to find a way to convert currency at significantly lower cost than what you would lose from withholding taxes. That’s not as easy as it sounds. Norbert’s gambit is excellent for converting large amounts, but even that is not free (it’s about 20 bps if done properly). And it’s impractical for smaller amounts and for inexperienced DIY investors.
The capital gains issue, as far as I can tell, is a red herring. US-listed Vanguard and iShares equity ETFs almost never distribute capital gains. If someone can find a specific example, please share it.
http://bit.ly/ZuEIYu
http://us.ishares.com/topics/capital_gains.htm
In a perfect world, we would be able to buy Canadian-domiciled mutual funds that directly held thousands of international stocks and carried an MER in line with these ETFs. The closest you can get today is DFA funds, but even these cost about 70 bps or more and they’re not available to retail DIY investors. We can wait for the ideal product to come along, but in the meantime we need to use the best tools available, even if they are imperfect.
@Park: I would be surprised if we did not see an unhedged version of VUS from Vanguard soon, maybe even this year. For the record, ETF providers aren’t much interested in what bloggers have to say about hedging, but they listen to advisors, and there’s lots of yammering from advisors about how now is a good time to tactically shift to unhedged portfolios. I wish people would understand that hedging is a strategic, long-term decision, not a tactical one based on where the dollar is today.
@Death and Taxes: DRIPs have zero effect on withholding taxes, just as they have no effect on income taxes. Either way, you’re paying the tax.
Ok good to know thanks Dan(I’m still buying them for the growth potential regardless.)
@CCP:
Thanks for putting the disadvantages of US-listed ETF in perspective with the available choices in Canada.
Do you know why US-listed ETF would not distribute capital gains while Canadian ETF do? Is it because of higher trade volume?
From one of your earliest post in 2010:
“More important for Couch Potato investors, ETFs are cleverly designed so that some are able to virtually eliminate taxable gains. The structure is complicated, but the basic idea is that ETFs do not have to keep cash on hand to pay investors who redeem their shares. The underlying stocks or bonds in an ETF are held by a third party called a designated broker, and the creation and redemption of units are made through in-kind swaps between this broker and the ETF sponsor. Because no cash exchanges hands, no taxable event is generated, and no capital gain is passed on to the investor. The system is not perfect, but many iShares and Claymore ETFs have never passed along a cent in capital gains to their unitholders.”
https://canadiancouchpotato.com/2010/01/22/couch-potato-basics-part-5-tax-efficiency/
@Jas: Trading volume isn’t a factor, but it seems that age is. The longer an equity ETF has been around, the less often it seems to distribute capital gains. I believe this is because the funds can build up a “runway” by harvesting losses and carrying them forward.
Bond funds are distributing capital gains these days because they contain bonds bought at a premium: another reason to avoid them in taxable accounts. (This is true even for well-established US bond ETFs.)
There are other factors too, including how often there are changes to the index. Total-market indexes, for example, are much less likely to have to sell companies that are removed from their index. Indexes with only a small number of holdings are more vulnerable.
Finally, currency hedging can be a big culprit. Look at the huge gains XSP distributed in 2012 (77 cents per share). Its underlying ETF distributed none, so that had to be the result of the futures contracts used to hedge the currency.
Hi Dan, thanks for the updates on new ETFs. This is definitely an incentive for me to start buying Canadian listed ETFs, rather than cheaper US listed ETFs. Even though I may be paying a bit more in management fees for Canadian ETFs, at least I won’t have the hassle of doing a US-Canadian dollar conversion (via Norbert’s Gambit) each and every time I want to make an ETF investment.
What are your views about the Horizon HXS S&P 500 ETF? (There is also the HXS.U ETF.) Its management fee is .15% which seems competitive to me. Is there any reason why it’s not included in your list of recommended ETFs?
cheers.
@Milhouse: HXS is a good product in taxable accounts, but note that there is an additional 30 bps fee for the swap structure, so its full cost is actually 0.45%. So you would have to enjoy significant tax savings to make it worthwhile.
In the interest of disclosure, I should say I hold a small amount of HXS in one of my accounts at Scotia iTrade because it trades commission-free and is therefore cheaper than any other option, regardless of the tax benefit.
https://canadiancouchpotato.com/2011/06/06/understanding-swap-based-etfs/
I noticed that each of these 3 new ETFs only show a “Total Annual Fee” on their website and in the prospectus the same figure is called the “Annual Management Fee”. This appears to be another annoying attempt to mislead investors about the total costs (the MER)! Since the prospectus doesn’t have any data for these new funds under the section titled “Annual Returns and Management Expense Ratio”, how can we determine the true MER for these ETFs?
What the canadian investor really need is an unhedged, canadian domiciled equivalent of VTI and VXUS !
About HXS and swap based ETFs in general, they’re a good deal for retail investors, for Horizons and for the counterparty providing the swap (National Bank?). These good deals come at the expense of the government. Since the government sets the rules, I wonder how long this will persist.
Once you get around $80K per year, capital gains starts to be taxed less than Canadian dividends. And when it comes to foreign dividends, capital gains are always taxed at a lower rate. With these swap based ETFs, there is also tax deferral. And you don’t need to worry about foreign withholding taxes and whether you’ll get credit for them.
So from a tax point of view, it’s not surprising that Horizon’s ETFs are popular. The more popular they are, they more likely the government will act. Will they be victims of their own success?
However, foreign domiciled swap based ETFs complicate the issue. If the government forbids domestic swap based ETFs, one can use foreign swap based ETFs. Can the government prevent Canadian investors from purchasing such ETFs?
If the government does away with swap based ETFs (think of income trusts and advantaged ETFs), there will be capital gains taxes to be paid. Swap based ETFs may switch from being tax efficient to very tax inefficient.
@Elbyron: An ETF cannot measure its MER until it has been in existence for at least one year, since some costs can’t be known in advance. A fund’s actual MER will be disclosed in its annual Management Report of Fund Performance, usually published in late March each year.
@Park: No one can guarantee the government won’t ultimately sour on swap-based ETFs, but I have spoken to Horizons about this several times. They’ve assured me the counterparty is responsible for paying the taxes, but they are presumably taking advantage of some kind tax arbitrage. Swaps have been around for decades and the government has never expressed any concern, which is quite different from their unease with forward-based ETFs and income trusts that have resulted in lost revenue.
A few points about comments above.
One of the main reasons for lack of capital gains distributions in many broad US listed ETFs is the way ETF units are created/redeemed. The ETF manager can choose which tax lots to assign in the redemption process which essentially “disappears” the lots with the highest accumulated capital gains. Unless an ETF is fairly new, has been launched at a market bottom and has few redemptions(see VSS in its early years), it’s unlikely to have to distribute cap gains.
Park, the counterparty for HXS is TD, National Bank is the counterparty on HXT.
As others mentioned, still waiting for true Canadian funds that track EAFE and EM affordably. That being said, my research indicates US listed ETFs pay significantly less foreign taxes(not recoverable to Canadians) than true Canadian funds investing in the same foreign countries. VEA/VXUS only pay a little over 6% on average in foreign dividend taxes, about half of what Canadian funds pay(recoverable in unregistered). Therefore a Canadian fund would only be beneficial in unregistered, from a total cost perspective, if its MER was less than about 20 basis points above its US counterpart. That’s likely to be a tough target to achieve in the Canadian market for years to come.
@gsp:
TD e serie international index fund (TDB911) has a MER of 0.5 and one level of witholding tax that is recoverable from the CRA.
US-listed ETF of international equities have another level of withholding taxes that is not not recoverable. Depending on the dividend yield, CCP estimates that this had 30-45 basis point to the total MER (ETF’s MER + 0.3-0.45).
Vanguard VEA has a MER of 0.12 and VXUS 0.18.
The new ishare ETF XEF has a MER of o.3
If you add 0.3 to 0.45 for the non recoverable withholding tax of these three funds, the overall MER is very similar, or even higher, than TD eseries fund.
One advantage of US-listed ETF might be that they will have less (maybe none) capital gain distributions compared to the TD e ser