Buying China ETFs in Canada: Is it worth it?

China stocks are ranked 22nd on the global scale, with a forward price-to-earnings (P/E) multiple of just 10.85. The appeal of buying into this valuation gap is obvious, especially for those seeking growth potential and global diversification. 

As a Canadian investor, you’ve probably come across several exchange-traded funds (ETFs) on the Toronto Stock Exchange offering exposure to Chinese equities. But before you rush to buy, it’s worth hitting the pause button.

Here’s my take on why Canadian-listed Chinese equity ETFs may or may not be worth it. 

The double whammy of foreign withholding tax

Some Canadian-listed Chinese equity ETFs are shockingly tax-inefficient. Take the iShares China Index ETF (XCH), for example. With $123 million in assets under management, it tracks the FTSE China 50 Index. 

Here’s the catch: It doesn’t hold the stocks directly. Instead, XCH holds the U.S. dollar-denominated iShares China Large-Cap ETF (FXI). This is where the tax inefficiency kicks in. 

The Chinese-domiciled stocks in FXI are subject to a layer of foreign withholding tax in China before the dividends even reach FXI. Then, FXI itself is hit with a second layer of withholding tax—15% from the U.S.—as it’s held within XCH. 

The result is a double whammy of tax drag, where the same dividends are taxed at multiple points along the chain before you even consider your domestic Canadian tax exposure. To reiterate:

1. First layer: China taxes the dividends before they reach FXI.
2. Second layer: The U.S. imposes a 15% foreign withholding tax when FXI dividends are passed to XCH.

The only way to sidestep the second layer of 15% U.S. withholding tax is to skip XCH entirely, convert your Canadian to U.S. dollars, and buy FXI directly in a registered retirement savings plan (RRSP). But that results in additional currency conversion costs.

High management expense ratios

By and large, the options for Canadians seeking Chinese equity exposure are prohibitively expensive, even compared to mutual funds. 

Take XCH for example, with its hefty 0.86% management expense ratio (MER). The more specialized BMO MSCI China ESG Leaders Index ETF (ZCH) isn’t much cheaper, charging a 0.67% MER. For a $10,000 investment, that’s $86 and $67 in annual fees, respectively.

Now compare this to Canadian equity ETFs, where fees can be as low as 0.05%, like the TD Canadian Equity Index ETF (TTP). That’s just $5 a year for the same $10,000 investment.

The MER is a consistent drag on your performance, especially over the long term. It’s a headwind you’ll feel year after year, so it’s worth aiming to keep it as low as possible.

Expensive trading costs

There’s one Canadian-listed Chinese equity ETF I want to like: the CI ICBCCS S&P China 500 Index ETF (CHNA.B). With a lower 0.59% MER, that fee is still on the high side but remains relatively competitive in this segment. 

Unlike many peers, it holds stocks directly, avoiding the second layer of 15% U.S. foreign withholding tax. It also includes exposure to China A-shares, which are domestically traded Chinese stocks typically inaccessible to foreign investors—a notable advantage.

However, one issue keeps me skeptical: the bid-ask spread. As of December 5, CHNA.B had a bid price of $22.79 and an ask price of $22.86, resulting in a spread of $0.07, or about 0.31%.

ETF liquidity is influenced not just by trading volume but also by the liquidity of the underlying assets. This is why large-cap Canadian and U.S. equity ETFs often have extremely tight spreads, even when volume is low—the underlying stocks are highly liquid. 

Conversely, CHNA.B struggles with wider spreads because it holds less liquid Chinese equities, leading to higher overall trading costs for Canadian investors. 

The final word on Chinese equity ETFs

Before you invest in a dedicated Chinese equity ETF, consider whether you actually need one for your mix of assets. If you own an asset allocation ETF like the Vanguard All-Equity ETF Portfolio (VEQT), you already have the “recommended” exposure to Chinese equities. VEQT currently allocates 7.13% to the Vanguard FTSE Emerging Markets All Cap Index ETF (VEE), and with China making up 29.44% of VEE, you’re already getting about 2.1% exposure to Chinese stocks. 

For additional China exposure, you could consider buying VEE itself—it has a relatively modest MER of 0.25%—but then you’ll end up with broad exposure to emerging markets like India, Taiwan, and Brazil as well as China.

I’m not here to dissuade anyone from exploring Chinese equity ETFs entirely. The valuation gap between Chinese and developed markets (especially the U.S.) is enormous. However, it’s crucial to be aware of the potential risks, such as high fees, tax inefficiencies and wide bid-ask spreads.

For some Canadian investors, these drawbacks may outweigh the benefits of increasing your exposure to China.

Read more about ETF investing:

• Demand for active ETFs is growing among Canadian investors
• Two ways to lower risk in your investment portfolio with ETFs
• What is the price of gold in Canada? And more about gold investing
• Why and how to increase small-cap exposure with ETFs

About Tony Dong, MSc, CETF

Tony Dong has been published on USA Today, U.S. News & World Report, TheStreet and more. He is also the lead ETF analyst for ETF Central, and he holds The ETF Institute’s Certified ETF Advisor designation.

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