I used to own one of those one-piece cutlery tools designed for hiking and camping—the kind with a knife, fork and spoon that all fold into a single unit. It was hardly ideal for eating, especially if you needed the fork and knife at the same time. But it was more convenient than trekking around with three individual pieces of flatware that might tear your pack or get left behind on the trail.
As investors we often make similar trade-offs. Consider the Vanguard FTSE Global All Cap ex Canada (VXC) or the iShares Core MSCI All Country World ex Canada (XAW), which both offer one-stop global diversification by holding thousands of US, international and emerging market stocks. But as with folding cutlery, you give up something to get that convenience. These two “ex Canada” funds get at least some of their exposure by holding underlying US-listed ETFs rather than holding their stocks directly. This structure can result in additional foreign withholding taxes on dividends.
In a recent blog post, Justin Bender estimated the impact of foreign withholding taxes on RRSP investors who hold VXC. He then considered how investors might reduce those taxes by instead holding its four underlying US-listed ETFs. The results were pretty dramatic: if you also factor in the management expense ratios, the total cost of VXC in a retirement account is 0.71%, compared with just 0.19% for the US-listed ETFs.
For investors who use XAW, the drag caused by foreign withholding taxes is somewhat smaller, because not all of its stocks are held via US-listed ETFs. But the overall cost is still substantially higher than it would be if you held the underlying funds directly in your RRSP.
Because of these savings in management fees and taxes, we generally use US-listed funds for our clients who hold foreign equities in RRSPs and related accounts (such as LIRAs and RRIFs). But when we work with DIY investors we typically recommend Canadian-listed options, whether it’s a single-ETF solution like VXC or XAW or a trio of funds covering US, international and emerging markets separately.
Why the inconsistent advice? Because with any investing decision, you need to consider the bigger picture rather than viewing a single factor in isolation.
A fair exchange
While the cost of holding US-listed ETFs is lower compared with their Canadian counterparts, the cost of purchasing them can be much higher. While most brokerages now allow you to hold USD in registered accounts, they still tend to gouge you on currency conversion. Unless you are able to convert your loonies to US dollars at a very low rate—for example, by using Norbert’s gambit, as we do—the advantages of US-listed ETFs will be reduced.
It’s not unusual to pay 1% to 1.5% when converting modest amounts of money (under $50,000 or so) at an online brokerage. If holding US-listed funds reduces your MER and foreign withholding taxes by 0.52%, as Justin estimates, it would take two or three years to break even compared with simply using Canadian ETFs. And don’t forget you’ll likely want to convert your currency back to CAD when it comes time to draw down your RRSP in retirement. That would add another two or three years to the break-even period.
In my experience with DIY clients, Norbert’s gambit often seems confusing and a bit intimidating. When I present the choice and explain the differences in cost, most investors prefer to accept the higher cost for the added convenience of trading only on the TSX.
Keep ’em separated
Even if you agree that holding Canadian-listed ETFs is the way to go, why not hold three separate ETFs for US, international and emerging market equities instead of getting your knife, fork and spoon in a single fund like VXC or XAW? After all, the overall MER would be lower and you’d be able to customize your asset mix.
That’s a perfectly good option, and Justin’s own model ETF portfolios are built that way. Indeed, in the hands of an experienced portfolio manager, separating these asset classes adds more flexibility. With our clients we’re often managing large portfolios with multiple accounts and we may wish to hold, for example, international equities in an RRSP and US equities in a non-registered account. You can’t do that with a single “ex Canada” ETF.
However, holding individual ETFs also complicates your portfolio by adding three moving parts instead of just one. That means significantly more rebalancing, which carries costs in the form of trading commissions, bid-ask spreads and capital gains taxes in non-registered accounts. With small portfolios you may find yourself making frequent small trades, especially in emerging markets, since that ETF will likely have a target of just 2% to 5%.
More important, separating these asset classes adds another behavioural challenge. During the periods when the US is running well and international and emerging stocks are struggling, it’s easy to succumb to the temptation to buy what’s hot instead of what’s below its target—which, of course, undermines the whole idea of rebalancing. With a single ETF for all your foreign equities, there are fewer opportunities to make that mistake.
Using a fund like VXC or XAW might not be the optimal choice, especially for experienced, disciplined investors with large portfolios who are able to do currency exchange cheaply and trade at low cost. But for those who are focused on getting broad diversification with low fees and minimal complexity, an “ex Canada” ETF is still a useful tool to keep in your pack.
Just about to buy my first ETFs through questrade but this whole FWT stuff confuses the heck out of me. I want to buy ZAG (10%) VCN (30%) and XAW (60%) with 10k. What will my annual costs be MER + FWT? Also how do I find out the FWT% of an ETF? Thanks
@Mat: At this stage (with about $10K to invest) foreign withholding taxes are a trivial concern that you can safely ignore. We’re talking about a few dollars a year. Don’t tie yourself in knots: just get started.
Great advice:) just get started is my new motto!
I have a question about GRRSP’s. My work contributes a percentage of my max allocation, as long as I max out the rest. It’s basically free money!! So I don’t want to miss out on that. That being said, the actual investment options through desjardins is not what I had hoped for, with highest fees.
Should I transfer these out every year, and put them in my self directed account with questrade, or just leave them there and let the fund managers do their work?
Thanks in advance:)
@James: If your workplace plan allows you to transfer funds to another RRSP for little or no fee (many do) then it probably does make sense to do this once a year. But definitely take full advantage of your company match.
I plan to buy about $30K of XAW in my non-registered account to re-balance my portfolio but will keep the $30K of VXC, assuming it’s not worth incurring the $20 cost to sell the VXC and then buy XAW. Same for the <$15K each in LIRA and TFSA. But is it worth selling $50K of VXC in my RRSP in exchange for XAW, for the lower FTW?
Hi! I’m loving your blog, and using it to start my investing journey. I want to buy ZAG (25%) VCN (25%) and XAW (50%). I have about 80k cdn that I’ll divide up between ZAG and VCN but I’m not not what to do about XAW. I have about 65k USD in a US equity that I’d like to diversify to reduce my risk… Is it better to do Norbert’s Gambit to convert it into Canadian and put that in XAW vs. finding a similar ETF that’s US held, and keep it in USD? Or a mix?
@Jilly: If you’re using an RRSP there would be a benefit to keeping the USD and using US-listed ETFs for US and international equities. But in other account types, it’s probably best to do Norbert’s gambit once and be done with it. Then you can use Canadian-listed ETFs going forward.
Is it more riskier to hold ETFs that invest in other ETFs rather than ETFs that actually holds stocks?
What would be the pros and cons?
Thank you very much
@Annick: There is no difference in risk.
Hi there I’m over here from MMM and am in the process of investing a $100,000 in my RRSP to cover a capital gains from a sale of property. I started with just three etf’s (in fact your 2017 portfolio) … now I am seeing that maybe that isn’t optimal??? My issue is that I am such a new investor I don’t want to create issues for myself later on … I am just learning to rebalance though so maybe I should stick with just the three …. argh lol….
@SweetLife: The three-ETF portfolio sounds like it is just fine for your situation. No need to strive for “optimal,” as there is always a chance of doing worse by trying to do more.
Regarding this :
“ There is no single US-listed ETF equivalent to VXC or XAW. You would need to use one fund for US equities (such as VTI or ITOT) and one or two others for overseas stocks (such VXUS, or a combination of IEFA and IEMG).”
I saw that there is XAW-U (XAW in USD).
Would it be a good idea to buy this one instead in my RRSP in USD (I already have some USD)?
@Patrice, no. XAW.U is not US listed, simply US denominated. It will suffer the same tax withholding issues as XAW.