The Pros and Cons of Investing in U.S. Securities
Living in Canada, it is almost impossible to ignore the United States. It is bigger than us in almost every way, except geography. Arguably, the U.S. has more influence over the world than any other nation and has maintained that influence for decades.
The size, influence, and power that the United States wields extend to the financial world, too. The two words “Wall Street,” are synonymous with financial power. All the major financial institutions, if they are not headquartered in New York City, are likely to maintain significant offices there. The major Canadian banks, as well as many other publicly listed Canadian companies, maintain listings on the New York Stock Exchange.
Vanguard, the US-based investment giant, has an ETF that is listed under the symbol VT. Its name is the Vanguard Total World Stock ETF. This ETF has 9,017 stock holdings. Those stocks are held in proportion to the market capitalization (size) of the various companies. You will probably not be surprised that eight of the top ten holdings are U.S.-based companies. Overall, by market capitalization, U.S. companies make up 57.7% of the index that VT tracks. Japan is a distant second at 6.6%. Canada is 5th at 2.7%. If an investor wants a diversified investment portfolio, ignoring the United States is a difficult choice to make.
Having said that, investing outside of Canada isn’t without its issues. In this post, I will consider some of the pros and cons of investing in the United States.
As mentioned above, almost 60%of the world’s stocks as measured by market capitalization are domiciled in the United States. When Canadians only invest in Canadian stocks, whether through mutual funds, ETFs, or directly, we miss out on a lot. About 32% of Canada’s stock market is made up of financials like Royal Bank, TD Bank, and Manulife. The next largest sector at approximately 13% is Materials such as Barrick Gold and Nutrien, followed by Energy also at 13%. In this category, you may be familiar with Enbridge, TC Energy, and Canadian Natural Resources.
In the U.S., these categories do not have quite the same level of significance. Financials make up 12%, and Materials and Energy make up 3% each. The two biggest heavy hitters in the U.S. stock market are Information Technology at 25% and Health Care at 13%. Buying a broad-based U.S. index ETF will diversify your investment portfolio considerably.
Ability to Invest in US Dollars
Although travel to the United States has been limited for this last year or so, given our proximity, many Canadians have U.S. dollars and travel back and forth frequently. They might have a U.S. dollar bank account and/or a U.S. dollar credit card. Investing a portion of one’s assets directly in U.S. dollars may be sensible in that case. Dividend payments made in U.S. dollars can help fund travel as well as generate growth in an investor’s net worth.
Most Canadian Brokerages Allow U.S. Dollar Accounts
For the most part, you can invest in U.S. stocks or ETFs by holding U.S. dollars. In the past, not every account made that option available. You would have to buy your U.S. investment using Canadian dollars and then deal with the foreign exchange conversion and the associated costs. This is no longer the case for most account types.
No Withholding Tax in RRSPs/RRIFs
Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs) are recognized by the US Internal Revenue Service (IRS) so, if you hold US stocks or US-domiciled ETFs in your RRSP or RRIF, you get to keep the entire dividend. Since it is also tax-sheltered while in the account you don’t have to worry about paying tax to Canada either.
Foreign Tax Credit Available in Non-Registered Accounts
If you own a US-domiciled ETF or stock in a non-registered account, the IRS will withhold 15% of the dividend that you receive. Fortunately, since the assets in non-registered accounts are not sheltered from Canadian taxation, investors can submit this withholding tax, which will be documented on a T-slip, so that they can claim back some of this cost.
Foreign Exchange Costs
Foreign Exchange can impact you in two ways.
First, if you have a U.S. dollar (USD) side to one of your investment accounts, whether RRSP, TFSA, or non-registered, you have to get USD into that account. Some investment firms will arrange for you to deposit USD into the U.S. side without any foreign exchange costs involved. But, if you lack USD, you may have to convert your Canadian dollars (CAD) into USD using a foreign exchange transfer from the Canadian side to the U.S. side. Just as stock transactions have a bid and ask price, so also do foreign exchange transactions. When you buy USD, you will pay more in CAD. And, when you sell your USD to buy CAD, you will receive less.
As an illustration, consider you want to buy USD1,000. Let’s assume the mid-point of the exchange rates is CAD1.20 = USD1.00. USD1,000 would be equal to CAD1,200. When you are buying USD, you will have to pay more, though. In our example, let’s assume that means CAD1.21 = USD1.00. You will have to pay CAD1,210. If you sell your USD to buy back CAD, you will only get CAD1.19 for each USD1.00. That means your USD1,000, will come back to you as CAD1,190. Currency fluctuates, of course, so it might work in your favour, or it might work against you. The point is, though, that foreign exchange will impact your returns.
A second way in which foreign exchange can cost you is if you hold U.S. stocks or ETFs in a CAD account. Purchases and sales of U.S.-domiciled securities may result in foreign exchange costs every time there is a transaction. In addition, there may also be foreign exchange charges whenever a dividend is paid from the U.S. security. Over time, this can become a significant cost to your returns.
TFSAs and RESPs are not Tax-Efficient for US Stocks
Unlike the case with RRSPs, TFSAs and RESPs are not recognized account types in the U.S. As a consequence, U.S. withholding tax will be applied to any dividends received. Furthermore, since assets in these accounts are tax-sheltered from the perspective of the CRA, you cannot claim the foreign tax paid to the U.S on your tax return.
Potential US Tax Filing Obligations for Your Estate
If you own greater than $60,000 of U.S. situs assets at your death, you are obligated to file a U.S. estate return. This requirement extends to U.S.-domiciled stocks or ETFs held in your Canadian investment accounts, including your RRSP or RRIF. Fortunately, you are unlikely to have to pay tax to the IRS, but the additional obligation this places on your executor makes this something to consider avoiding.
US Source Dividends are not Tax-Advantaged
Eligible dividends from Canadian companies have a tax advantage in non-registered accounts. Not so dividends from U.S. sources. For tax purposes, they are treated just like interest income, fully taxable at your marginal tax rate.
Complications in Filing Taxes in Canada
Fortunately, rules for capital gains and capital losses apply to U.S. stocks and ETFs the same way they do to Canadian securities. However, foreign exchange does come back to bite you here, too. Imagine you had a USD non-registered account. Every April 1 for the last five years you had bought approximately USD5,000 of SPY, the SPDR S&P 500 ETF Trust. This last Friday, May 28, you sold your accumulated 86 shares at a price of USD420.04 per share. The exchange rate at the time of the sale was CAD1.2086 per USD1.00. Proceeds to you were:
86 x 420.04 = $36,123.44. The T5008 you will get from your broker will show those proceeds and will show an Adjusted Cost Base (ACB) of $24,969.47. It’s a straightforward calculation:
$36,123.44 – $24,969.47 = $11,153.97. You then convert the gain in USD to CAD by using the 1.2086 exchange rate. That makes your net gain CAD13,480.69.
As this is a capital gain, with an inclusion rate of 50%, the taxable amount is $13,480.69 x 50% = $6,740.34 in CAD.
However, that’s not what you are supposed to do. You need to tally up your costs in CAD for each purchase. Notice the difference in outcomes in the table below.
The column headed by USD in blue provides the outcome if done according to the incorrect scenario described above, which would probably be what you get if you were to go by the T5008. However, the CAD column in red provides the correct answer and reduces the taxable gain by almost $1,200.
All this is to say that managing your taxes when trading in USD in a non-registered account can be quite complicated.
A Humble Suggestion
Use Canadian-listed ETFs
While there are definite pros to investing in USD, you may want to confine your investing to foreign securities that are available to be purchased through Canadian-domiciled ETFs or funds. It’s not a defeat to simplify your investing life. As I get older, simplicity is gaining greater appeal, but I think it has great appeal to even the younger person who wants to do more with their life than fiddling with spreadsheets all the time.
Use USD-denominated but Canadian-listed ETFs
If you want the USD, but don’t want the exposure to U.S. estate tax filing, this may be helpful. Many mutual funds and ETFs provide USD equivalents to their U.S. equity funds. As these are listed on Canadian exchanges, your holdings are no longer on the radar of the IRS. True, this may not be the most tax-efficient approach, but which is more important to you? Wringing every last basis point (1/100th of a percent) out of your investments or designing and implementing an investment policy that you can live with for the long term?
What About Currency-Hedged Funds?
Finally, Canadian investors can buy ETFs and mutual funds that use derivatives to hedge against the risk of fluctuations in the USD against the CAD. In recent months, for example, the CAD has risen against the USD such that gains on the US stock market have not been reflected in equivalent gains for us who live our lives in CAD. A currency-hedged fund will attempt to compensate for that movement by seeking to give you the equivalent gain in CAD. In other words, an investment in a US security with a 10% gain in USD will equal a 10% gain in CAD. Unfortunately, this same hedging works against you when the USD goes up against the CAD. The US investment might have a 10% gain in USD but if your U.S. investment is hedged, when the CAD is weakening against the USD you will still only get a 10% gain while the parallel unhedged investment will see Canadian investors with greater than 10% returns in CAD terms.
I don’t have a strong opinion about whether an investor should use hedging or not. The argument against hedging is that, in the long run, the fluctuations in the exchange rate will even out. It can even be said that since you get an additional element of diversification by exposure to a different currency, it can be to your benefit not to hedge your U.S. investments. Furthermore, hedging strategies are more complex and tend to raise the price of managing the fund, leading to poorer results in the long run.
The argument for hedging is that the investment return is more consistent with your expectations regardless of the direction of the Canadian dollar. If we are in a phase when the CAD is on an upward trend, currency hedging may be very helpful. It’s a tough call to make. If you do not have a strong conviction either way on this matter, the middle of the road solution may work for you. That is, divide your U.S. holdings 50/50, meaning 50% hedged and 50% unhedged. It’s not perfect, but it may be the least-worst option.
This is the 100th blog post for Russ Writes.
Click here to contact me for an appointment.
You may be interested in a half-hour no-cost, no-obligation financial planning conversation with me. Click here to sign up for a free session of FinPlan30.
Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.