It is now more than one year since Vanguard came to Canada by launching its first set of Exchange-Traded Funds (ETFs). Last week, I had a chance to chat with Atul Tiwari Chief of Vanguard Canada. I asked him a few of my questions and those of Canadian Money Forum members (here) about Vanguard’s plans for the future, ownership structure and securities lending policies.

It is now over an year since Vanguard launched its first suite of ETFs. The flagship Vanguard MSCI Canada Index ETF (VCE) has just $91 million in AUM. Can long-term investors assume that Vanguard is committed to doing business in Canada?

We are very pleased with where Vanguard Canada is today, exactly one year (Dec. 6th) after our launch. We have $430 million in assets and accounted for 12.5 percent of inflow into ETFs in the categories of our 6 core products to date in 2012. Investors can be confident that Vanguard plans to be in Canada for a long, long time. That’s because Vanguard has expanded into new markets in a careful, deliberate fashion.

Any comment on upcoming ETFs?

We will be launching our third tranche of ETFs in 2013. We are looking into launching unhedged versions of Vanguard EAFE Index ETF (CAD-Hedged) (TSX: VEF) and Vanguard MSCI US Broad Market Index ETF (TSX: VUS) but our plans are not final.

Vanguard in the US offers extras to investors with $50,000 or more in assets such as commission-free ETF trading, financial plans etc. Are there any plans to launch similar services in Canada in the future?

Vanguard in the US operates a brokerage that allows it to offer clients commission-free ETF trading. We don’t have plans to offer such services in the near future. Canadian investors wishing to purchase Vanguard ETFs can currently do so through brokerages such as iTrade and others that offer them.

ETFs such as VEF and VEE which are wraps around US-listed ETFs. Will these ETFs hold component securities directly at some point in the future?

The issue is cost. It is very expensive to buy and take custody of foreign shares in Canada compared to the United States, which has the deepest capital markets in the world. Vanguard is aware that holding wrap ETFs in registered accounts incurs a cost and investors should weigh that against the benefits of not having to convert currencies and US estate tax implications. Withholding taxes should be only one of the factors you consider when you invest.

Can you comment on the ownership structure of Vanguard Canada? Is it similar to that of the US, where Vanguard is set up as a mutual company in which the company is owned by the funds and the interests of Vanguard’s are aligned with that of investors in its funds?

Vanguard Canada is set up as a subsidiary of Vanguard US. Since Vanguard in the US is set up as a mutual company in which the mutual funds own the fund company, and it operates on an “at cost” basis, it translates into lower costs for investors over time. Vanguard Canada will operate on the same principle. At present, we are in start-up mode, so essentially Vanguard US fund holders are subsidizing investors in Vanguard’s Canadian ETFs. As the ETFs gather more assets and the operations become profitable, the profits will, in effect, flow back to investors in the form of lower fees.

Can you comment on your securities lending policies? What about collateral? Is there a chance, however remote, that the collateral can turn illiquid or experience losses? (Interested readers may want to check out this paper on how Vanguard practises securities lending).

Vanguard does securities lending differently from other ETF vendors. First, there is no securities lending in fixed-income products. In equity ETFs, only a small percentage of a fund’s assets — between 1 to 5 percent, typically around 3 percent — are lent out. Vanguard lends out only scarce securities to earn better fees. For example, Vanguard ETFs will not generally lend a stock such as IBM that is easily available for borrowing. It should be noted that unlike other firms that allocate a significant portion of lending revenues to their management companies, Vanguard returns all lending revenues, net of broker rebates, program costs, and agent fees, to the funds for the benefit of investors. Vanguard invests the collateral in high quality short term instruments, such as Government securities or cash deposits and marks to market daily at 102-105%.

This article has 11 comments

  1. On securities lending, is the MER net of securities lending income, or is it separate from the MER? For example, consider VCE with a management fee of 9 bp. Suppose that the full costs with taxes, trading costs, etc. comes in at 12 bp, just to pick a figure. If they make 20 bp on securities lending, does this mean that we can expect VCE to outperform its index by 20-12=8 bp, or are the costs really 20+12=32 bp?

  2. VEF and VUS are very good news. However, we will still lose foreign withholding taxes on EAFE and EM funds. From what I understand, if Vanguard provided the information required by the CRA, we could get foreign tax credits.

    Overall though, I am happy that Vanguard is in Canada. Except for the loss of foreign withholding taxes, at least 95% of Canadian investors will have all they need with the addition of the new Vanguard funds.

    I’d like to make the following provocative proposal. Vanguard should be allowed to market the same mutual funds in Canada, as it does in the USA. There should be minimal red tape. For Canadian investors, the funds would be in Canadian dollars and should provide the information by the CRA for maximal tax efficiency.

    I know of no restrictions on hedge funds. Why are there restrictions on Vanguard mutual funds? It looks like the regulatory authorities think that Canadian investors don’t need protection against hedge funds; why must we be “protected” against Vanguard mutual funds?

    • Vanguard USA operates under US tax laws, which are quite different from the Canadian ones. The distributions mandated by the two sets of tax laws are different and I don’t see how the same instrument could declare different amounts. So unfortunately your provocative proposal cannot be implemented (not that they have not thought of it, most likely).

  3. @Park: VEF holds VEA. VEA paid withholding taxes to foreign governments. VEF paid withholding tax to IRS. Vanguard will issue tax slips showing the 15% withholding tax paid to the IRS. Canadians receive a foreign tax credit if VEF is held in taxable accounts. I don’t know of any mutual fund or ETF that will show withholding taxes paid to foreign governments. I can inquire around and find out if this is even feasible. I doubt that it is.

    I’m not sure allowing funds operating under foreign laws to market to Canadians is a good idea. Vanguard is one of the good guys but it sounds to me that any change has the potential for malfeasance.

  4. Canadian domiciled mutual funds and ETFs show withholding taxes paid to foreign governments. The wrap funds don’t. If the wrap funds provided the necessary annual returns and accounting that conforms with CRA rather than IRS tax reporting/accounting rules, would the CRA accept this?

    Yes, tax laws are different. This would required some work by the wrap funds. But wrap funds can be large; XIN has around $750 million in assets. I’ve owned mutual funds domiciled outside Canada and the USA.. It did take some work to go through the financial statements to determine my taxation, but I could do it by myself. I am not an accountant. If I can do it, I don’t see why a fund with $750 million in assets can’t do it. Is it not feasible because Canadian investors haven’t lobbied enough for it? How many Canadian investors know of this hidden taxation?

    On a separate topic, why not have free trade in mutual funds between Canada and the USA? We have free trade in cars and hedge funds. Canadian have benefited from such free trade (some might disagree about hedge funds). I’m not aware that American regulators are inferior to Canadian regulators. Canadians don’t need to be “protected” from American mutual funds.

    Even if one doesn’t believe in free trade in mutual funds, why not minimize the red tape, so Canadianizing an American mutual fund would require little expense?

    • @Park: Let’s say I hold VEA in my taxable account. VEA paid withholding taxes to foreign governments. I haven’t heard of anyone able to get a foreign tax credit for these taxes. I would personally be interested to investigate a way to claim the FTC even if I have to do the legwork myself.

      I agree that the US regulatory framework should be good enough (in fact, it is probably better) for Canadians, so that shouldn’t be an argument for preventing us from buying US mutual funds. The cynic in me thinks that the ones needing “protection” are Canadian mutual funds, not investors.

  5. At present, we are in start-up mode, so essentially Vanguard US fund holders are subsidizing investors in Vanguard’s Canadian ETFs. As the ETFs gather more assets and the operations become profitable, the profits will, in effect, flow back to investors in the form of lower fees.

    Interesting and honest answer.

    Good interview.


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