S&P 500 ETFs like Vanguard S&P 500 Index ETF (TSX:VFV) have long provided Canadians with a hassle-free and affordable way to invest in the U.S. stock market.
However, as stellar as VFV is, it isn’t suitable for every investor in every situation. The construction of VFV comes with nuances that could potentially lead to confusion or, in a worst-case scenario, panic selling if you’re not fully aware of what you’re getting into.
Let’s look at two specific reasons why VFV might not be the best fit for your investment strategy. We’ll go over two alternative ETFs that could be better picks depending on the scenario.
It’s not currency-hedged
VFV operates by taking your Canadian dollars, converting them into U.S. dollars, and then using those funds to buy shares of a U.S.-listed S&P 500 ETF that holds U.S. stocks.
This process exposes you to the fluctuations in the CAD-USD exchange rate because VFV is not currency hedged. This means that changes in the exchange rate can significantly impact your investment returns, for better or worse.
When the U.S. dollar strengthens against the Canadian dollar, as it has recently, VFV can be expected to outperform the S&P 500 when measured in Canadian dollars.
Conversely, if the Canadian dollar strengthens against the U.S. dollar, as it has at times in the past, your investment in VFV could underperform compared to the S&P 500.
If you prefer to avoid this additional layer of volatility caused by currency fluctuations, you might consider a currency-hedged version of this ETF. One such option is Vanguard S&P 500 Index ETF (CAD-hedged) (TSX:VSP).
It’s subject to foreign withholding tax
As a Canadian-listed ETF that holds U.S. assets, VFV is subject to a 15% foreign withholding tax on the dividends it distributes.
This deduction can significantly impact your overall returns, particularly when compared to what you might have earned had all dividends been fully reinvested without the tax impact.
This withholding tax is unavoidable for Canadian investors holding U.S. assets in non-registered accounts or TFSAs. However, there is a way to bypass this tax if you are investing through a Registered Retirement Savings Plan (RRSP).
By investing in a U.S.-listed ETF, such as Vanguard S&P 500 ETF (NYSEMKT:VOO) within a Registered Retirement Savings Plan (RRSP), you can avoid the foreign withholding tax due to the tax treaty between Canada and the U.S., which recognizes RRSPs.
However, it’s important to consider the currency conversion factor. Investing in a U.S.-listed ETF requires converting Canadian dollars to U.S. dollars, which can come with its own costs unless you have a cost-effective method of currency conversion.
If such conversions prove too costly or complex, sticking with VFV might still be the better option despite the 15% withholding tax on dividends, as it simplifies the investment process and eliminates currency exchange concerns.
