In the comments section of last week’s post about the Cheapskate’s Portfolio, reader W.B. asked why I recommend US-listed ETFs from Vanguard for the US and international equity components. His brokerage charges a 1.5% currency conversion fee, and W.B. argued that this hefty cost would outweigh the savings he’d get buy using US-listed funds with lower annual MERs.
I knew that the US-listed ETFs would be the better deal over the long run, but I couldn’t be specific about the break-even point, because I had never actually done the math. The calculations aren’t straightforward: in addition to the currency fees and MERs, you also have to consider the different ways each ETF is taxed.
Well, now I have done the math. I created an Excel spreadsheet that readers are welcome to download. I had to make several assumptions, but I have designed the spreadsheet to be flexible: you can easily change the amount invested, the currency conversion fee, the projected returns, and the MER of the funds you’re comparing. (Just be careful not to bugger up the formulas!)
Here’s the thought process that went into building the spreadsheet:
- I have included two worksheets: the first assumes a single lump-sum contribution of $100,000 CAD, while the second assumes a $5,000 annual contribution. You can easily change either amount to suit your circumstances.
- If the brokerage charges 1.5% every time Canadian dollars are exchanged to US dollars or vice-versa, then the investor in the US-listed ETF loses 1.5% on each contribution, and he loses another 1.5% when he cashes out at the end of the investing period. The 1.5% fee also applies to all dividends received from the US-listed ETF.
- The ETFs are considered to be held in an RRSP. Therefore, the US-listed ETF is exempt from the 15% withholding tax on foreign dividends.
- I assume that the Canadian ETF simply holds the US-listed version of the same fund. There are several common examples of this in Canada: iShares XSP doesn’t directly hold the stocks in the S&P 500, but rather holds the iShares S&P 500 Index Fund (IVV). The same goes for iShares XIN, which holds the iShares MSCI EAFE Index Fund (EFA), and Claymore’s CWO, which holds the Vanguard MSCI Emerging Markets ETF (VWO). These ETFs are subject to the 15% withholding tax on foreign dividends. For more on this confusing but important tax rule, see this post by Canadian Capitalist.
- I assume the Canadian ETF provider does not incur any foreign exchange fees on its transactions, or when receiving dividends. (In reality this cost is not zero, but when I asked iShares about it, they explained that they get institutional rates which make it negligible — perhaps a basis point or two.)
- The MER of the US-listed fund is assumed to be 0.09%, while the cost of the Canadian ETF is 0.26%. (This is the actual cost difference between IVV and XSP. Again, you can easily change it if comparing two other ETFs.)
- Every year, I assume the funds earn a 7% total return, consisting of a 5% capital gain and a 2% dividend yield. This return is before deducting the fund’s MER and withholding taxes.
- Finally, I had to assume that the Canadian-listed ETF does not use currency hedging. In the real world, both XSP and XIN do hedge currency. (The Canadian version of the iShares MSCI Emerging Markets Index Fund (XEM) does not, however, so the assumption is not baseless.) Unfortunately, there’s no meaningful way to include currency fluctuations in an illustration like this one.
You can download the spreadsheet for all the details, but here are the highlights: the US-listed ETF doesn’t take the lead until year 7 with lump sum contribution, and it takes 11 years to break even with the $5,000 annual contribution. In both cases, however, by the end of a 20- or 30-year period, the cost advantage of the US-listed fund is huge. The investor who made the $100,000 one-time purchase is almost $70,000 ahead after three decades.
There is a lot more to say on the topic of foreign equity ETFs, including suggestions on how you can dramatically lower that 1.5% currency exchange fee, and a look at whether the currency hedging in Canadian ETFs is really a good deal. We’ll look at both these issues later in the week.