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U.S. market ETFs: To hedge or not to hedge?

rcarrick@globeandmail.com

You can't be a serious exchange-traded fund investor in this country and not have looked enviously at the cheaper and more varied ETFs listed in the U.S. market.

Many investors have done more than look at U.S. ETFs. According to Bank of Montreal's ETF division, Canadians hold about $20-billion (U.S.) worth of ETFs listed on U.S. exchanges. There are some great U.S. ETF products, but they're not always a good choice for Canadians.

To start with, owning U.S.-market ETFs listed on the New York Stock Exchange can have an impact on whether a Canadian is affected by U.S. estate tax. Today, estate taxes apply to people who have U.S. assets included in worldwide holdings that are valued at more than $5-million (U.S.). Wayne Bewick, a chartered accountant with Trowbridge Professional Corp., said the threshold will fall to $1-million as of Jan. 1, unless changes are made by the U.S. government.

"One way of avoiding U.S. stocks being subject to U.S. estate tax is by buying a Canadian ETF," Mr. Bewick said in an e-mail. "Canadian ETFs are not likely subject to the U.S. estate tax if they track U.S. indexes."

There are some issues with Toronto Stock Exchange-listed ETFs that track U.S. indexes, though. They're comparatively expensive and, in the past, they've included the mixed blessing of currency hedging. Help is here, though.

In the past month or so, both BMO ETFs and Vanguard's Canadian ETF division have introduced low-priced S&P 500 ETFs that dispense with hedging. These ETFs are a good alternative to U.S.-listed S&P 500 ETFs, although frugal investors will chafe at the idea.

The management expense ratio for the BMO S&P 500 ETF (ZSP) and the Vanguard S&P 500 ETF (VFV) is in the range of 0.17 per cent. That's a very low cost when viewed against the universe of competing domestic products, but not in comparison to the U.S.-listed competition. The NYSE-listed version of the Vanguard S&P 500 Index ETF (VOO) has a management expense ratio of 0.05 per cent, and its closest competitors, the iShares Core S&P 500 ETF (IVV) and the SPDR S&P 500 ETF (SPY) are at 0.07 per cent and 0.09 per cent, respectively.

Why not buy VOO at 0.05 per cent instead of VFV at 0.17 per cent? In fact, there's a tax-related argument for doing just that, if you're investing in a registered retirement account. According to Vanguard, $1 in dividends paid by VOO would turn up in retirement accounts as $1. You can thank a Canada-U.S. tax treaty for that.

The same courtesy does not apply to VFV in registered accounts, though. It's structured in such a way that the U.S. withholding tax eats 15 cents of every $1 paid in dividends, and there's no way for investors to recover that money. In non-registered accounts, VOO and VFV are treated equally. Investors lose 15 cents of every $1 in dividends to withholding taxes, but they can claim credit for this amount when filing their income tax returns.

The big reason to consider VFV over VOO has to do with currency conversion. If you were to buy VOO, your broker's markup on the conversion of Canadian dollars into American could range from 0.5 to 1.85 per cent. When you buy VFV instead of VOO, you can regard the extra 0.12 of a percentage point in fees as the cost of currency conversion and various portfolio management functions.

Dean Allen, head of product management for Vanguard Investments Canada, suggests investors ask about the cost of converting their loonies into U.S. dollars. If it's more than 0.12 of a point, "then on that measure alone [VFV] might be the better choice."

There's still another new TSX-listed ETF option for investing in the S&P 500 - the BMO S&P 500 Index ETF (U.S. Dollar Units), which trades in U.S. dollars and uses the symbol ZSP.U. If you have U.S. dollars to invest in the S&P 500 and want to avoid the U.S. estate tax, this new fund is an alternative to NYSE-listed funds.

Fluctuations in the Canada-U.S. currency exchange rate aren't an issue with ZSP.U because it's designed for people who invest in U.S. dollars and don't intend to convert them into Canadian dollars. But with VFV and ZSP, where there's no currency hedging, your S&P 500 returns will be either helped or hindered by our dollar's fluctuations.

Hedging ideally blocks out currency-related distortions in your returns. But there are a couple of drawbacks to hedging in the form of higher costs and tracking error, a term that describes the differential between the returns of an ETF and the index it targets (ideally, the difference would entirely be explainable by the ETF's fee).

In the BMO and iShares ETF groups, hedged S&P 500 ETFs have MERs around 0.25 per cent. Vanguard's new hedged S&P 500 - VSP is the stock symbol - is cheaper at about 0.17 per cent. With any hedged ETF, expect periods where the inherent imprecision of hedging causes significant tracking error of up to a percentage point or more.

Where ZUE, VSP and other hedged S&P 500 ETFs make sense is in a market in which the Canadian dollar is rising against its U.S. counterpart. The more the loonie rises, the more it eats into S&P returns in U.S. dollars.

With the Canadian dollar perched just above parity, there's arguably more downside than up. If the dollar were to fall a bit, that would add to your S&P 500 returns. Prefer not to guess whether hedging is the right move? Then think about a mix of both a hedged S&P 500 ETF such as ZUE and an unhedged fund like ZSP.

Expect to see Canadian ETF companies offer more unhedged U.S. market ETFs in the future. If you consider U.S. estate taxes and foreign exchange costs, these ETFs look more attractive than buying in the American market.

For more personal finance coverage, follow me on Twitter (rcarrick) and Facebook (Rob Carrick).

*****

TIPS OF THE TRADE

Four ways to invest in the S&P 500 with ETFs

1. TSX-LISTED S&P 500 ETFs WITHOUT CURRENCY HEDGING

Your return is whatever the S&P 500 makes, converted into Canadian dollars and minus fees.

FUND...........................................TICKER.......FEE

BMO S&P 500 Index ETF.............ZSP..........0.17

Vanguard S&P 500 Index ETF.....VFV..........0.17

2. NYSE-LISTED S&P 500 ETFs

Your return is whatever the S&P 500 makes in U.S. dollars, minus fees.

FUND..................................................TICKER......FEE

iShares Core S&P 500 Index Fund.....IVV..........0.07

SPDR S&P 500 ETF............................SPY.........0.09

Vanguard S&P 500 ETF......................VOO........0.05

3. TSX-LISTED S&P 500 ETFs WITH CURRENCY HEDGING

The target return is whatever the S&P 500 makes in U.S. dollars, with protection against any impact from currency moves (minus fees).

FUND.......................................................................TICKER....FEE

BMO S&P 500 Hedged to CAD Index ETF............ZUE.......0.25

Horizons S&P 500 Index (C$ Hedged) ETF..........HXS........0.17

iShares S&P 500 Index Fund (CAD-Hedged).......XSP.......0.25

Vanguard S&P 500 Index ETF (CAD Hedged).....VSP.......0.17

4. TSX-LISTED S&P 500 ETFs TRADED IN U.S. DOLLARS

For people who want to invest in U.S. dollars and don't foresee converting them back to Canadian dollars.

FUND.....................................................................TICKER.......FEE

BMO S&P 500 Index ETF (U.S. Dollar Units).....ZSP.U........0.17

THE GLOBE AND MAIL

SOURCE: ETF COMPANY WEBSITES

© 2007 The Globe and Mail. All rights reserved.

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