Tired of seeing your stock picks go nowhere? It’s a feeling many investors can relate to. And in these moments, it might seem like a no-brainer to turn to tried and tested exchange-traded funds (ETFs) that track major indices like the S&P 500.
Vanguard S&P 500 Index ETF (TSX:VFV) stands out in this regard, especially among Canadian investors, boasting popularity, high trading volume, and a good deal of assets under management.
The perks of VFV are notable. It comes with a low expense ratio of 0.09%, offers high diversification by tracking 500 of the largest U.S. companies, and has displayed strong historical performance.
However, despite these apparent advantages, VFV might not be the silver bullet or no-brainer buy for everyone’s portfolio. Let’s delve into two reasons why and explore some ETF picks that might complement or even substitute it.
Reason #1: Lack of Canadian exposure
For Canadian investors parking all their money in an ETF like VFV, there’s a glaring omission: the Canadian stock market.
Firstly, it provides higher representation in sectors that the U.S. market might be underexposed to, such as energy, financials, materials, and utilities. These sectors not only diversify an investor’s portfolio but also offer a hedge against potential downturns in tech-heavy U.S. indices and protection against inflation.
Moreover, Canadian stocks generally have a reputation for paying better dividends. For income-seeking investors, this could be a key attraction. On top of that, dividends from Canadian companies are taxed much more efficiently.
For those looking to incorporate Canadian exposure, iShares Core S&P/TSX Capped Composite Index ETF (TSX:XIC) is an excellent choice. With a low expense ratio of just 0.06%, it provides broad exposure to the Canadian market.
Reason #2: Currency risk
One of the oft-overlooked factors when investing internationally, especially for those new to the scene, is currency risk. For Canadian investors placing their bets on VFV, this risk is tangible and should not be ignored.
Currency risk manifests when the value of one currency fluctuates relative to another. In the case of VFV, the ETF’s underlying assets are priced in U.S. dollars, but for Canadian investors, any returns are converted back to Canadian dollars.
This means that even if the S&P 500 posts solid gains, a strengthening CAD against the USD could erode those gains when translated back.
For instance, imagine the S&P 500 goes up by 10% in a year, but during the same period, the Canadian dollar appreciates by 5% against the U.S. dollar.
In this scenario, the net return for a Canadian investor would be diminished, reflecting both the market gains and the currency loss.
To mitigate this, consider Vanguard S&P 500 Index ETF (CAD-hedged) (TSX:VSP). As VFV’s hedged counterpart, VSP offers a layer of protection against currency fluctuations.
By employing currency hedging strategies, VSP aims to neutralize the impact of the CAD/USD exchange rate movements on returns. This means that if the S&P 500 goes up by 10%, VSP aims to deliver close to that 10% return in CAD terms, irrespective of where the Canadian dollar moves relative to the U.S. dollar.