Buy Low-Cost U.S. Index Funds But Hedge Your Bets Canadians Can�t Avoid Currency Risk

Richard Morrison Canadian stock markets took a steep plunge in February and as of mid-May were still down on the year. My wealthy friend Jim, however, is ahead so far in 2018, thanks to his disciplined approach of buying on dips, holding for the long term and reinvesting the dividends. Jim’s approach has made him wealthy. Smug and irritating, but wealthy. During a recent afternoon playing pool in the billiard room of his palatial home, Jim was even more smug and irritating than usual.

“Nine in the corner,” Jim announced, then banked the nine-ball off the end cushion into a corner pocket to win the game. “I’m lucky, but good players are always lucky.”

Jim’s Canadian stocks consist of the big banks, insurance companies, telecoms, utilities, railways and manufacturers but no resource stocks or small caps. The portfolio has consistently outperformed the S&P/TSX Composite index.

“Outperforming U.S. markets is more difficult. There are millions of shrewd investors trying to beat the market down there,” he said. “You may as well just buy an Exchange Traded Fund with a low Management Expense Ratio that tracks the S&P 500.”

Warren Buffett, chairman of Berkshire Hathaway Inc. and arguably the world’s most successful investor, would agree. Mr. Buffett has consistently urged investors to buy index funds or broad-based ETFs instead of trying to pick market-beating individual stocks.

“I gave Buffett the idea,” Jim said.

Last year, Mr. Buffett demonstrated that paying a professional investor exorbitant fees to try to outperform the market is even worse than trying to pick stocks yourself. In 2007, Mr. Buffett wagered $1-million that a low-cost index fund could consistently outperform a basket of hedge funds over the following 10 years. At the end of 2017, Mr. Buffett won the bet, as his fund of choice, the Vanguard 500 Admiral Shares, had registered a compound annual return of 7.1%. The other side of the wager, taken by fund manager Protege Partners, had an average increase of only 2.2%. The U.S.$1 million value of the wager— actually U.S.$2.2-million, since it was invested in Berkshire itself in 2012— went to an Omaha, Nebraska girls’ charity.

For Canadians who don’t want to pay professionals to pick U.S. stocks for them but don’t feel confident enough to pick individual U.S. stocks themselves, low-fee Exchange Traded Funds (ETFs) fit the bill. There are a variety of low-cost U.S. ETFs that have Management Expense Ratios (MERs) of less than one tenth of one per cent, or $1 per $1,000 invested. That compares with some Canadian mutual funds, whose fees can carve off 2% of each year’s gains.

The BMO Investorline discount brokerage site lists 449 U.S. equity ETFs, of which 13 have MERs of less than 0.1% and a track record of at least five years. Almost all have achieved returns of between 13% and 14% over the past five years, although none have been able to escape this year’s downturn, slipping from 2% to 3% so far in 2018.

Since they simply track the S&P 500 index, these funds all hold the same giant companies: Apple Inc., Microsoft Corp., Amazon.com Inc., Facebook Inc., Berkshire Hathaway Inc., JP Morgan Chase & Co., Johnson & Johnson, Exxon Mobil Corp. and Alphabet Inc., formerly Google.

Here are some of the largest U.S. index-tracking funds with the lowest fees:

SPDR S&P 500 ETF (SPY/NYSE):

Launched in 1993 the SPDR S&P 500 ETF Trust, known colloquially as Spyders, is the oldest and largest ETF, with U.S.$255.86-billion in assets. Compared to others in the group, the trust’s MER is a relatively expensive 0.09%.

Vanguard S&P 500 ETF (VOO/NYSE):

This 10-year-old fund has U.S.$87.96-billion in assets and charges less than half of SPY, with a MER of just 0.04%.

iShares Core S&P 500 ETF (IVV/NYSE):

Like the Vanguard fund, this 18-year old fund carries a MER of just 0.04%.

Canadians with taxable accounts may prefer the TSX-listed equivalents of the above funds. These include the iShares Core S&P 500 Index ETF (XUS/TSX) with an MER of 0.1%, and the Vanguard S&P 500 Index Fund (VFV/TSX), which carries an MER of 0.08%.

For investors who question the longevity of relatively new giant companies such as Apple, Facebook, Amazon and Alphabet (Google), funds that focus on dividends and those that describe themselves as “value” funds leave out most of the Internet-fuelled names. These funds focus on more well-established, dividend-paying giants such as Exxon Mobil, Microsoft, Pfizer Inc., Intel Corp., The Home Depot Inc., Verizon Communications Inc., Walmart Inc., PepsiCo Inc., Procter & Gamble Co., 3M Co. and IBM Co.

Among the giant, low fee U.S. funds whose holdings avoid the newer giants are three Vanguard funds: Value (VTV/NYSE), Dividend Appreciation (VIG/NYSE) and High Dividend Yield (VYM/NYSE), together with the Schwab U.S. Dividend Equity ETF (SCHD/NYSE).

Canadian Dollar Hedged U.S. ETFs

Canadians seeking U.S. investments of any sort face currency risk. Regardless of how carefully a Canadian investor researches and analyzes a U.S. investment, there is no getting around the fact that currency fluctuations will have a big effect on returns. For example, a Canadian who bought U.S. investments in 2009 and sold in 2011 would have suffered a big loss as the loonie appreciated, then enjoyed a big gain over the next five years as the Canadian dollar weakened.

Canadians can protect themselves against currency risk via Canadian-dollar-hedged ETFs, but these are relatively expensive and thanks to tracking error, inefficient. Many market experts say that in the long run, currency fluctuations even out so you should not bother hedging your investments. As well, Canadians who spend a lot of time in the United States or anywhere else where the U.S. dollar is accepted (and have a U.S.dollar account) may never need to repatriate their U.S.dollar denominated investments back into Canadian dollars.

In my opinion, retirees do not have the luxury of waiting for the “long term” for currency fluctuations to even out. A young person with many working years ahead of them can easily weather a currency fluctuation loss, but older investors may have to repatriate their U.S.dollar denominated holdings earlier than they planned.

Jim had unhedged ETFs in his portfolio until his health made travel problematic. That’s when he closed his U.S. dollar accounts, sold his U.S.dollar denominated ETFs and bought Canadian-dollar-hedged ETFs.

“If I’m stuck here I might as well hold the only currency I can spend,” he said.

Over the past five years, Canadian-dollar-hedged funds that track the S&P 500 have achieved average annual total returns in the 12.5% to 13% range, while unhedged funds have returned 13% to 14%. So far this year, however, hedged funds are down only about 1%, vs. 2% to 3% for unhedged ETFs.

Canadian-dollar-hedged ETFs that track the S&P 500 include the iShares Core S&P 500 ETF (XSP/TSX), launched in 2001, with $4.19 billion in assets and a MER of 0.11%, the six-year-old Vanguard S&P 500 ETF CAD-H (VSP/TSX), with $652 million in assets and a 0.08% MER, and the $1.0 billion BMO S&P 500 Hedged to CAD ETF (ZUE/TSX), launched in 2009, with a 0.1% MER.

Like their U.S. dollar denominated counterparts, these three hedged ETFs track the entire S&P 500. There are a variety of other Canadian-dollar-hedged ETFs with relatively low MERs that track the U.S. market. For example, Canadians who want to avoid holding Alphabet, Amazon.com, Apple and Facebook can buy units of the iShares U.S. Dividend Growers ETF CADH Comm (CUD/TSX), which carries an MER of 0.66% or the iShares U.S. High Dividend Equity ETF CADH (XHD/TSX) with an MER of 0.33%.

Conclusion

Canada’s stock market is small enough that most of the time, investors can achieve better returns than the TSX simply by avoiding resource stocks and taking a buy-and-hold approach to shares of banks, telecom companies, insurers, utilities and a few large manufacturers. Returns can be dramatically improved using dividend reinvestment plans, or DRIPs.

The U.S. market is many times larger and more complicated than Canada’s, and the returns from funds that track the S&P 500 are far less tied to resource stocks. A broad U.S. market index with low fees is often the better choice than individual U.S. stocks. For those who worry that Apple, Amazon.com, Alphabet and Facebook won’t be the biggest companies in the world 10 years from now, there are low-priced ETFs that leave out the relatively new giants.

Richard Morrison, CIM, is a former editor and investment columnist at the Financial Post. richarddmorrison@yahoo.ca