Canadians wanting to get exposure to the US stock market through an ETF have a range of options. They could choose to invest in the well-known S&P 500 index, which is composed of 500 of the largest-capitalization stocks listed in the US. A better option is to track a total market index, which includes almost every stock listed on the US exchanges. Burton Malkiel, explains the rationale in the latest edition of A Random Walk Down Wall Street:

The S&P 500 omits the thousands of small companies that are among the most dynamic in the economy. Thus, I now believe that if an investor is to buy only one index fund, the best general U.S. index to emulate is one of the broader indexes such as the Russell 3000, the Dow-Wiltshire 5000-stock index, or the MSCI broad U.S. Index – not the S&P 500.

The Vanguard Total Stock Market ETF, which trades under the ticker VTI, tracks the returns of the entire US market (the MSCI index) for a rock bottom MER of 0.07%. If you buy-and-hold this one ETF, you will capture the entire US market, including small caps, for a very modest cost.

ETFs that track the S&P 500 index, which are listed on American exchanges and hence denominated in US dollars are SPDR 500 (Ticker symbol SPY, also known as Spiders) and the iShares S&P 500 Index Fund (Ticker symbol IVV). There is little to choose between SPY and IVV: they cost almost the same to own (IVV – 0.09% and SPY – 0.10%) but the SPY is a lot more liquid. If you invest in either the SPY or IVV, you would obtain the returns of the S&P 500 (less modest expenses) translated into Canadian dollars.

Canadian investors also have the option of tracking the S&P 500 using the iShares CDN S&P 500 Index Fund, which is listed on the TSX with the ticker symbol XSP and denominated in Canadian dollars. XSP, simply owns the US-listed IVV, and adds a currency hedge on top of it. Of course, you’ll pay an extra 0.15% as a cost for the hedge for a total cost of 0.24% (0.09% for the IVV and 0.15% for the XSP). The hedging enables investors to capture the return of the S&P 500 in Canadian dollars without the gains or losses due to currency fluctuations.

My personal preference is to invest directly in US-listed ETFs without hedging currency exposure because in my opinion, hedging is simply chasing performance after the Canadian dollar has run up significantly. Recall that hardly any mutual fund or ETF engaged in hedging when the loonie was in the dumps but now it is a popular selling feature. Why pay an extra fee when currency fluctuations will even out over the long term? It is so predictable – investors are always fighting the last war.

NB: I apologize getting fairly technical in yesterday’s post and not doing a better job of explaining the terms. Thanks to Steve for pointing out my error. I really appreciate it.

This article has 26 comments

  1. Good info. It looks like VTI really takes care of the US market assuming you want to have a complete index.

    Question: I know the ETF companies always publish the MER but I get the impression that this isn’t really the same as the MER of mutual funds which seem to capture most of the actual costs. Maybe I’m just being paranoid (or skeptical of the low costs) but it will be interesting to see how close these ETFs track their index.

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  3. Mike what makes you think the MER of an ETF isn’t really the same?

    I don’t think you should be “interested in seeing how close these ETFs track their index.” ETFs have been around for a long time.

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  5. Canadian Capitalist

    Dave: Tracking error is a legitimate concern for index funds and ETFs. VTI from what I understand is pretty good at tracking the index though it does omit some illiquid stocks.

  6. Dave, you might be right but unfortunately I can’t help the things I’m “interested in”.

    ETFs as a category have been around a while, I don’t know about a long time though. Regardless ,most of the ETFs available today have not been around long at all.

    On the ishares.ca site there is a tool where you can check out the tracking error for a period of time. If you try it for XIN for 2006 (between 30/12/2005 and 29/12/2006) you’ll see that the tracking error was 1.89%. The fund returned 16.76% and the index returned 18.65%.

    The MER is 0.5% so what happened to the other 1.39%? According to the website:

    “The main causes of performance difference are transaction costs, annual fees, rebalance costs and portfolio optimisation.”.

    This was the worst example I found so I’m not saying all ETFs are like this every year.

    One of the other ETFs I looked at was XIC which had the following annual errors from 2001 to 2006: +1.25%, -1.67%, -1.56%, -0.89%, +2.88%, -0.24% which ends up being -0.31% over 6 years which is only a bit more than the 0.25% MER. I’m thinking (and I want to see more data over time) that if you hold these ETFs for a long time then hopefully the tracking errors might balance out and you will end up with a return that reflects the index return minus the MER like XIC did over the 6 years it’s been around.

    I think as a DIYer it’s important to learn as much as possible about the stocks/products that you are investing in which is why I’m interested in the tracking error.

  7. Mike, sorry I meant you shouldn’t be interested in seeing how well they will track in the indexes by waiting and seeing what they do… there is probably plenty of historical data on this. I had been under the impression that they would balance each other out as you mentioned. Although I did read a website that talked in detail about all the disadvantages of ETFs a long time, I really can’t remember too much about what it said. I should definitely go and read it again.

    Thanks for providing those numbers for me, you’ve gotten me interested.

  8. Haha, now that I reread your post I see what you mean.

    You’re right about the historical data although I haven’t had much luck finding too much so far (not that I’ve looked much).

  9. Canadian Capitalist

    I don’t know why XIN has a high tracking error. I am guessing it may be due to the switch in mandate from using derivatives to actually holding EFA. The tracking error for EFA is quite acceptable if you look at the chart on the iShares website.

    Also, the theoretical tracking error for EFA is expected to be higher than VTI because of withholding taxes on dividends. For example, I hold EFA in my RRSP but don’t pay any withholding taxes on dividends. I also hold Nokia and taxes are withheld on every dividend payment.

  10. Thanks for the info Stephanie. Although the fundamental indexes sound interesting I’d like to wait and see if the actual returns can replicate the back-tested results.

    The link on your name leads to the Claymore.ca site – do you work there? If so, perhaps you can add some info regarding tracking error for pure index ETFs?

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    Stephanie: I am aware of the fundamental indexes and have mentioned them in many posts. However, FI does have its share of critics (including such names as Bogle, Malkiel and Sharpe) who think that FI is just active management by another name and doubt that their outperformance of traditional indexes will persist into the future. In my personal portfolios and in my benchmarks, I am sticking with traditional index funds. I’ll wait and see how the debate and future performance plays out.

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  23. In the article, you measure the cost of hedging by simply taking the difference in MER between an unhedged and a hedged fund. Is this the right way to do it? I have read that currency hedging costs are not included in the MER (https://secure.globeadvisor.com/servlet/ArticleNews/story/gam/20090606/STMAIN06ART1915).

    It seems unrealistic that currency hedging can be achieved with only 0.15% cost, especially with the large CAD/USD exchange rates changes seen over the last decade. Also, I would think that if large changes in the exchange rate are considered probable, it would be extremely expensive to buy the futures contracts needed to hedge.

  24. @Raul: No, it’s not. This is one of the earlier posts I wrote and you are right that MER differences are not the only cost in holding currency-hedged ETFs. These ETFs have atrocious tracking errors. I’ve covered this topic in depth on this blog. Please see:

    http://www.canadiancapitalist.com/category/investing/currency-hedging/

    It’s not futures contracts that’s the source of the large tracking errors. It is the tendency of US stocks and Canadian dollar to move in opposite directions, at least in the recent past.

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