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.
Is there an advantage to having only VXC for international exposure, versus having a mix of VUN, VIU and VEE (like they do in the Vanguard all-in-one ETFs)?
@Arielle: Yes, holding one ETF instead of three is much easier to manage.
@Canadian Couch Potato
Makes sense! However could there be an advantage to having it the other way around?
@Arielle: The MER would be slightly lower if you held the three ETFs individually, but in my opinion this is not usually worth adding more moving parts.
@Canadian Couch Potato
As always, my apologies if you answered this someplace else. But with regards to your model ETF portfolios, are there any comparable US-market-based ETFs that you would recommend which would more or less mirror VEQT or XEQT on the equity side and VAB or XBB on the fixed-income side of a balanced/diversified portfolio?
Basically, I have a sizeable amount of US cash (as a currency offset) that I would like to invest in a similar manner as my Canadian currency.
@Len: Canadian investors can certainly integrate USD into a traditional index portfolio, but there a few key ideas to understand.
First, funds such as VEQT and XEQT are significantly overweighted in Canadian equities relative to the country’s share of the global market. They’re specifically designed for Canadian investors. The US has many “all world” equity ETFs, but obviously none of these overweights Canada. A good example is Vanguard’s VT, which simply holds the global market with a 2.7% allocation to Canada.
Along the same lines, there are of course many USD bond ETFs that play the same role as VAB or XBB. But a US bond ETF will be denominated in US dollars and will therefore be fully exposed to currency fluctuations. As a result, your returns (measured in CAD) will be driven more by the ups and downs of the US dollar than by the bond market. That’s why investors should generally not buy unhedged foreign bonds.
So, bottom line, I’d suggest using your CAD to hold bonds and Canadian equities, and to use your USD to hold US and international equities.