US Non-Resident Withholding Taxes and Asset Location

Dividends and interest from US securities are subject to the US Non-Resident Withholding Tax (currently 15%). However, the US-Canada Tax Treaty grants an exemption for certain registered accounts like RRSPs. So if you hold those securities in an RRSP (or certain other accounts), you will not be subject to the withholding tax. (Your brokerage usually handles getting this information to your ETF company so that they do not withhold the tax.)

Now that TFSAs are available, many people are treating them as an extension of the RRSP. But you should be aware that TFSAs are not exempt from the Non-Resident Withholding Tax under the US-Canada Tax Treaty.

So, considering only that you want to minimize the US Non-Resident Withholding Tax, the RRSP is the preferred location for applicable holdings. No withholding tax is applied. The next-best place is in a taxable account, because you can claim a foreign tax credit on the withholding tax paid. The worst place is the TFSA, because it is not exempt from withholding tax and on top of that, since it is not a taxable account, you cannot even claim the foreign tax credit.

BMO ETFs Have Started Trading

Four ETFs from BMO started trading on June 4, 2009. Descriptions directly from the press release:

• BMO Canadian Government Bond Index ETF (BGB) has been designed to replicate, to the extent possible, the performance of the Citigroup Canadian Government Bond Index.
• BMO Dow Jones Canada Titans 60 Index ETF (BCA) has been designed to replicate, to the extent possible, the performance of the Dow Jones Canada Titans 60 Index.
• BMO US Equity Index ETF (BUE) has been designed to replicate, to the extent possible, the performance of the Dow Jones U.S. Large-Cap Index (CAD hedged).
• BMO Dow Jones Diamonds^SM Index ETF (BDJ) has been designed to replicate, to the extent possible, the performance of the Dow Jones Industrial Average (CAD hedged).

BUE and BDJ both hedge exposure to the USD. The MERs for the funds are pretty low, undercutting iShares funds. Here's a comparison vs comparable iShares offerings:

Ticker	MER	# Holdings	Comments
BGB	0.341	28	Weighted Avg Duration 6.49; All Federal holdings; All AAA rated
XGB	0.35	86	Weighted Avg Duration 6.34; 63% federal, 34% provincial, 2% municipal; 68% AAA, 19% AA, 12% A
BCA	0.158	61
XIU	0.17	60
BUE	0.231	250
XSP	0.24	501	Invests in IVV, which has 501 holdings
BDJ	0.242	31	No iShares equivalent

BMO also plans to launch 3 other ETFs at a later date covering International Equities, Emerging Markets, and Global Infrastructure.

There isn't that much to say after only a couple of days of trading, but I will keep my eyes on these ETFs. There are only a few ETF sponsors in Canada, and before these BMO ETFs started trading, iShares was the only one tracking traditional market-cap indices. Here's hoping some competition gives rise to better (and lower cost) products.

Bond Investing

For the bond portion of my portfolio, I prefer to use short term bonds and the DEX Short Term Bond Index is probably the closest index to my bond strategy. In Canada, iShares' XSB is the best single ETF tracking the DEX Short Term Bond Index.

However, it still irks me to pay ongoing MERs on bonds when I could buy them individually and just hold them. I also don't like that bond funds' NAVs fluctuate such that it is quite possible to lose money holding bonds through a fund. Bond funds do, however provide the kind of diversification that is not really possible for anyone with less than $500,000 (or some big number like that) to invest.

Lately I've been thinking about how to solve this little problem, and I think I'll try it this way: Government bonds do not really require the diversification that corporate bond holdings do. There is only one issuer of Canada bonds, and only a handful of Provincial issuers. So for government bonds, it is easier to buy individual bonds without worrying so much about diversification.

Thus, appeal of something like iShares' XSB (MER 0.25%) is the diversified holding of corporate bonds. Looking at the iShares offerings, there isn't anything especially appealing for corporate bonds. XCB (MER 0.40%) has a duration that is a bit too long for my liking. Looking over at the Claymore offerings, though, we find the 1-5 Yr Laddered Corporate Bond ETF, CBO (MER 0.25%). CBO is fairly new, but trading volume is not bad for a Claymore fund. I do like that Claymore is offering DRIPs on all their funds now, so that is another plus for CBO.

CBO seems to hold about 70% A-rated bonds, and 30% AA bonds. The number of holdings is somewhat low, at 25, but 25 is also more than I would be able to buy on my own. The duration of the fund is 2.65, which I like. On the down side, there is no getting away from the possibility of losing money in the fund since its value fluctuates, but I think the diversification makes up for it as a corporate bond fund.

So in effect, my short term bonds will be split into government and corporate holdings. Asset allocators will probably like the opportunities to rebalance that this will allow for. There is only one ETF involved, so only one set of transaction fees are incurred when buying or selling. On the down side, when buying bonds from a brokerage, you don't really have a good idea what commissions are being charged. However, in Hank Cunningham's 2nd edition of In Your Best Interest, he investigated the bigger discount brokerages and found that TDW and BMO Investorline were the best for prices and in general found that discount brokerages were charging reasonable commissions on bonds.

The pros and cons of this approach:
Pros:

• Lower overall MER paid.
• Government bond component can be held to maturity.
• More control over allocations to government vs corporate bonds.
  

Cons:

• Overall less diversification than XSB.
• CBO has less diversification than XCB for the corporate component.
• A bit of a hassle to maintain the ladder of government bonds.
  

More Increases To Vanguard ETF Expense Ratios

It looks like the expense ratios on many of Vanguard's ETFs have changed recently. It wasn't that long ago that the expense ratio for VWO was raised by 0.02%.

Some other Vanguard ETFs of interest to Canadians have changed in the last few weeks:

• Vanguard's Total Stock Market ETF (VTI) has raised its expense ratio from 0.07% to 0.09% as of 04/29/2009.
• The expense ratio for the Vanguard Europe Pacific ETF (VEA) was raised from 0.15% to 0.16% on 04/24/2009
• All of their bond ETFs now have an expense ratio of 0.14%

Vanguard's expense ratios are still very low, but I hope this trend doesn't continue.

When to Buy a Currency Hedged Fund

Many international index funds have a version that is currency hedged as well as one that is not. For instance, in the TD e-series funds, there are non-hedged and hedged versions of the TD US Index and TD International Index funds. These funds can have drastically different performance numbers when the Canadian dollar fluctuates against the native currency or currencies of the companies in the index. Here are they yearly performance numbers for those TD funds.

Fund	2003	2004	2005	2006	2007	2008
TD U.S. Index	4.5	2.2	1.7	14.7	-11.1	-21.7
TD U.S. Index Currency Neutral	30.0	11.1	3.3	14.0	3.1	-39.0
TD International Index	13.4	10.9	10.2	25.5	-6.0	-27.9
TD International Index Currency Neutral	21.7	11.1	27.8	16.6	3.4	-42.2

Notice how in certain years, the performance of a fund's hedged (currency neutral) version can be quite different from the performance of the non-hedged version. This is because of currency fluctuations (tracking error also plays a part). In the case of the US index, the currency fluctuation is between the CAD and the USD, and in the International index, it is between the CAD and the various currencies in the international index.

Let's take a look at currency movements from 2003 to 2008:

So the currency neutral versions of the funds did better in years when the Canadian dollar rose against the US dollar. The non-hedged versions did better in years when the Canadian dollar fell versus the US dollar. Note that it is the change in the exchange rate and not the actual value of the exchange rate that affects returns.

Ideally, then, you want to buy the currency neutral version in years when the Canadian dollar is low, hoping to cash in when the CAD rises. Similarly, you want to buy the non-hedged version when the Canadian dollar is high, to take advantage of when the CAD falls.

Of course, timing such a move is pretty difficult, but we can look at historical data to get some idea of what could be considered a high or low Canadian dollar. Here is a chart of exchange rate data beginning in 1971 and ending May 2009:

I won't claim to know where the USD/CAD exchange rate will go, but this chart tells us that during this period, 1.00 CAD = 1 USD was pretty high, and around 1.00 CAD = 0.70 USD was pretty low. Again, I am not saying that this is how things will be in the future.

Using these numbers as a guide, we could perhaps set a rule to buy the currency hedged versions of the funds when 1.00 CAD is under 0.80 USD and buy the non-hedged version when 1.00 CAD is above 0.80 USD.

I can't guarantee that this will work in the future, but looking at the historical numbers, this appears to be a reasonable idea. There maybe other factors that would discourage this kind of thinking. For instance, you might not want to have two versions of the same index because of transaction costs or perhaps your currency hedged fund costs a lot more than your non-hedged version.

Also note that I've looked only at the CAD versus USD exchange rate. In international funds, you should consider the native currencies in the fund.

Another consideration: I am assuming that the investor wants to keep his/her investments in Canadian dollars. If you are open to holding the fund in US dollars, for example the TD U.S. Index ($US) (TDB952) instead of the TD US. Index Currency Neutral fund (TDB904), the fund in native dollars usually performs better than the one hedged in CAD due to tracking error. However, I think that the observations on currency fluctuations still holds.

And finally: Since currency movements are not predictable, and seem to even out over long periods, the choice between hedged or non-hedged funds probably isn't that important for the long term buy-and-hold investor, which is why this post is filed under the Noise tag.

Note: All chart graphics used in this post are © 2009 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada and were generated using the tool at http://fx.sauder.ubc.ca/plot.html.

iShares Sold to CVC

Barclays has sold iShares, the biggest ETF family in Canada, to CVC Capital Capital Partners Group. As Larry MacDonald writes, the chances of MERs increasing are probably higher for the Canadian iShares ETFs than in the US, where there is lots of competition.

Here in Canada, although we have ETFs from Claymore and Horizons, only iShares is offering market-cap weighted index ETFs. While I was previously not that excited by the upcoming BMO ETF offerings, maybe having some competition in the market-cap weighted index ETF space will be a good thing for investors.

Fund Fees for Currency Hedging

The performance of currency-hedged funds vs their non-hedged counterparts are largely based on currency fluctuations. Take a look at the yearly performance of the hedged and non-hedged TD e-Series funds. Everyone has an opinion on whether hedging is a good idea, and it seems to me that much of it has to do with recency.

In any case, I thought it would be interesting to see how much fund companies are charging for the benefits (whatever the benefits may be) of currency hedging:

Index/Sector	Hedged Fund	MER	Details	Hedging Fee
iShares
S&P 500	XSP	0.24%	Holds IVV (0.09%)	0.15%
Russel 2000	XSU	0.35%	Holds IWM (0.20%)	0.15%
EAFE	XIN	0.49%	Holds EFA (0.34%)	0.15%
Claymore
Core US	CLU	0.65%	Non-hedged CLU.C charges 0.65%	0.00%
Emerging Markets	CWO	0.65%	Holds VWO (0.27%). Since VWO is not a Claymore fund, the CWO MER is on top of what is charged by VWO.	0.65%
Global Dividend	CYH	0.65%	Holds 60/40 split of HGI (0.65%) and CVY (0.60%). Blended MER is 0.63%	0.02%
TD e-Series
US Index		0.48%	Non-hedged MER 0.33%	0.15%
International Index (EAFE)		0.50%	Non-hedged MER 0.48%	0.02%

Those are the currency-hedged funds I was able to find from iShares, Claymore, and the TD e-Series funds. I also wanted to look at the BMO ETFs, but will wait until they are actually trading before running through this exercise with them.

I'll let you decide whether or not currency hedging is a good idea, but you can see that funds are charging quite a wide range of fees for the service. iShares seems to charge a "standard" 0.15% which in my opinion is a little high. Then there is Claymore, with a wide range of fees depending on the fund, from 0.65% to hedge world currencies (CWO), down to 0% for US Dollars (CLU vs CLU.C). One point to note is that if you are interested in a hedged version of the EAFE index, it may be more cost effective to use the TD e-Series fund at 0.5% MER versus XIN which charges 0.49% MER since the TD e-Series funds don't incur transaction fees.

Vanguard Emerging Markets ETF Expense Ratio Raised

Looking over the Vanguard ETF site, I noticed that the expense ratio for VWO has been raised from 0.25% to 0.27%. The site says that this was changed on February 26, 2009. The expense ratio for VWO has bounced around slightly in the last few years. It was 0.30% in 2006 and then lowered to 0.25% in 2007.

Considering that the average ETF expense ratio in this category is around 0.55%, the Vanguard offering is still very good.