Watch out for foreign withholding taxes on ETFs

Early retirement planning (VisualField/Getty Images) — (VisualField/Getty Images)

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 U.S., 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 U.S.-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 U.S.-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 U.S.-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 U.S.-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 U.S.-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 U.S., 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 U.S.-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 U.S. dollars at a very low rate—for example, by using Norbert’s gambit, as we do—the advantages of U.S.-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 U.S.-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 U.S., 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 U.S. 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. This article was originally published on Canadian Couch Potato.