Pros and Cons of Cross-Border Shopping in the USA for ETFs

Cross-border shopping in the USA has long been a favorite activity of Canadians when the exchange rate vs the US dollar has swung in our favour. Investors looking for ETFs can shop cross-border too, as online brokers all provide seamless access to US stock markets with a click of the mouse on a drop down menu. What are the possible advantages and drawbacks of buying ETFs on US markets instead of the TSX in Canada?

The high Canadian dollar is not a reason to buy in the USA - The rise in the Canadian dollar does not create the same bargains in ETFs as it can in shoes. Buying the same thing in the USA and in Canada will not present the same bargains in ETFs because the much greater speed, volume and ease of moving money brings about a high degree of stock market efficiency – the same thing will at every instant cost the same amount, factoring in the exchange rate, on both sides of the border.

Pros – Reasons that favour buying ETFs in the USA

1) Management expense ratios – The lowest MER for an asset category is most often found in a US-based ETF. A good example is a fund that tracks the flagship large cap equity S&P 500 Index or something very similar. In Canada the lowest MER is Claymore's CLU.C with an MER of 0.71%, while in the US, the SPDR S&P 500 tracker (SPY) has a 0.09% MER.

2) Range of choice – US financial markets are many times larger than Canada's and that results in a much greater selection of ETFs. Whether it is US equity, international equity, emerging market equity or bond funds, there are more ETFs available. Sometimes there isn't even a comparable ETF in Canada for a key category, e.g. a whole of market US equity fund. Other worthwhile categories where there is a dearth of ETFs available in Canada include: Value stocks, Small cap stocks, foreign bonds.

3) High liquidity, reduced bid-ask spreads and lower tracking error – The size of the US market is reflected in the size of ETFs sold in its markets. Often the net asset value of a US fund is many times greater than that of a Canadian alternative. Trading volumes are consequently much higher and that tends to keep these sources of cost down and allow the investor to achieve returns that are higher and closer to the index they aim to track. For instance, the tracking error of Claymore's International Fundamental Index ETF (CIE) came out to 2.1% below its index in 2010 according to this Couch Potato blog post while the parallel US ETF, PowerShares' FTSE RAFI Developed Markets ex-US fund (PXF) has been tracking only about 1.1% below the same index. That amounts to a 1% extra “cost” of using CIE instead of PXF. It's worth checking several years of tracking error to see if it has varied a lot or if the pattern is consistent.

4) Unhedged versions of US and international funds – Due to anxiety amongst Canadian investors that our dollar will keep rising, it seems that almost all foreign equity ETFs sold in Canada come only in versions that hedge against currency shifts. Whether that is the best approach or even necessary is not cut and dried (see our post here on the pros and cons). Also, Canadian Capitalist has discovered that hedged ETFs are prone to especially bad tracking error.

5) US 15% withholding tax charged in registered accounts (RRSP, TFSA, RRIF, LIRA etc) – For Canadian-listed ETFs with foreign holdings consisting of US ETFs, such as iShares' MSCI Emerging Markets Fund (XEM) which holds only the US-listed EEM, the US government levies a 15% withholding tax on distributions that cannot be recovered. The constant reduction in net return is the 15% withholding tax times the fund dividend/distribution rate – e.g. 0.15 x 2% = 0.3% less. Other ETFs with this return-reducing problem include: Claymore's Emerging Markets (CWO), iShares Canada's S&P 500 (XSP), Russell 200 Index (XSU), MSCI EAFE Index (XIN), China Index (XCH), World Index (XWD). Our table below shows the various situations that can arise in ETFs regarding withholding tax. Green boxes show the minimal tax situation, red is bad with two layers of (US and international) withholding taxes that cannot be avoided or claimed as a credit against Canadian taxes and the clear boxes are where one withholding tax applies.


Cons – Reasons against buying ETFs in the USA

1) Currency exchange costs – Buying a US-listed ETF means having to pay in US dollars. The swap of Canadian dollars to buy the US currency can cost the individual investor up to 1.5% commission depending on the broker. Within a Canadian-listed ETF, the fund does the buying at lower institutional rates, which are usually so low as to be not worth worrying about. The problem is worst for registered accounts since selling the US ETF will result in conversion back to Canadian dollars at most brokers, a second big hit. The same hit happens to distributions by the ETF. An investor who wants to rebalance his/her portfolio by buying and selling might incur several round-trip currency conversions, each time with a return-reducing fee incurred. The problem is alleviated to a degree in several ways: by the fact that some brokers now allow US dollars to be held in a registered account after a sale; by many brokers allowing wash trades or by a fancy trading manoeuvre called Norbert's gambit (see Couch Potato's suggestions for reducing Forex fees)

2) Hedged ETFs not available – Despite the costs, some investors, such as those who are convinced the Canadian dollar will continue to rise or whose time horizon is too short for perhaps decades-long cycles to even things out, may still wish to diversify into foreign markets but with hedging against currency swings. In that case, US-listed ETFs are not the place to look – the only hedged US ETF hedges the US dollar against the rest of the world for the benefit of US investors.

3) Possible exposure to US Estate taxes – Only those whose worldwide assets exceed $5 million need to be concerned, but owning US ETFs makes one subject to US laws on estate taxes as we explained last December.

4) Automatic free dividend reinvestment, pre-authorized chequing purchases and systematic withdrawals – These extra services, available only in Canada from the likes of Claymore Canada and BMO Financial for their ETFs, avoid the costs of commissions on smaller purchases or sales and avoid having cash sitting around uninvested. Saving a $10 commission on a $200 purchase (a $10,000 holding with a 2% distribution gives off $200 a year) is a $10 / $10,000 = 0.1% saving on the holding's total expenses.

5) Withholding tax in a TFSA or RESP account – The US government levies a 15% withholding tax on distributions from US-listed ETFs to TFSAs, RESPs or non-registered taxable accounts i.e. anything other than accounts it recognizes as legitimate retirement accounts, such as RRSPs, RIFs, LRIFs, LIRAs, LIFs. That's on top of what the foreign countries already deducted in withholding tax. A Canadian-based ETF with direct international holdings such as BMO's International Equity Hedged to CAD ETF (ZDM), since it has nothing to do with the US, in contrast pays only the original foreign withholding tax and that tax shows up on T slips issued by the Canadian ETF provider as a foreign tax paid credit that can be used for taxable accounts. The RESP and TFSA still lose that amount but at least there is only one layer of taxation. How much can that reduce returns? Using for example a 2% distribution rate from the ETF holdings, the first level of withholding tax reduces it to 2% - (2% x 0.15) = 1.7% and the second level to 1.7% - (1.7% x 0.15) = 1.4%.

Bottom Line
Ask yourself whether you really want or need currency hedging. If yes, then Canadian-listed ETFs are the only option.

Otherwise, when there are directly parallel Canadian- and US-listed ETFs, add up the hard plus and minus costs associated with MER, Foreign exchange fees, Withholding tax, DRIP commission and Tracking error.

Happy cross-border comparison shopping from the comfort of your own computer!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.