I bought shares of Apple Inc. (AAPL) in 2016 (just after Warren Buffett did) for my tax-free savings account, not realizing that any dividends were subject to U.S. withholding tax. It hasn’t been much of a problem because Apple only pays $1 of dividends per share annually and yields less than 0.5 per cent. My shares have gained nearly 500 per cent and are now worth about $30,000. Now that Warren is taking some profits on his Apple shares, I am thinking about doing the same. However, I want to keep the money invested in the U.S. market and in U.S. dollars, and I was thinking of the BMO S&P 500 Index ETF (I am with BMO InvestorLine.) Would this exchange-traded fund also be taxable by the U.S.?
Yes. Any Canadian-listed ETF that holds U.S. stocks will be subject to 15-per-cent U.S. withholding tax on dividends paid by the underlying U.S. companies. With respect to BMO ETFs in particular, the BMO S&P 500 Index ETF (ZSP), its currency-hedged counterpart (ZUE) and the U.S-dollar version (ZSP.U) are all subject to U.S. withholding tax.
What’s more, the tax applies whether you hold these Canadian-listed ETFs in a non-registered account, tax-free savings account, registered retirement savings plan or any other account. Also, because you’re investing in a registered account, you won’t be able to claim a foreign tax credit for the tax withheld.
Now for the good news: The amount of tax we’re talking about is small. The S&P 500 Index currently yields about 1.3 per cent, and withholding tax of 15 per cent would eat up just 0.2 per cent of your investment annually. I wouldn’t let this stop you from investing in a particular ETF.
Under the Canada-U.S. tax treaty, you could avoid withholding tax on U.S. dividends by holding a U.S-listed ETF (as opposed to a Canadian-listed ETF) or U.S.-listed individual shares in an RRSP, registered retirement income fund or other account that is specifically for retirement purposes. Unfortunately for you, a TFSA doesn’t count in that regard. But, as I said, a small amount of withholding tax shouldn’t be a deal-breaker in your case.
Why is there so much tracking error with Nasdaq ETFs vs. the actual Nasdaq index? Consider that the Nasdaq index closed Fri., Aug. 23 at 17,877.79, up 1.47 per cent. However, all of Bank of Montreal’s ETFs that track the Nasdaq posted smaller gains that day. Specifically, ZQQ closed up only 1.04 per cent, ZNQ gained about 0.47 per cent and ZNQ.U rose about 0.96 per cent. What’s going on here?
For starters, this is not an apples-to-apples comparison. The index whose value you quoted is the Nasdaq Composite Index, which includes more than 3,000 companies traded on the Nasdaq Stock Market. But the three BMO ETFs you mentioned track the narrower Nasdaq-100 Index, which includes only the 100 largest non-financial companies on the Nasdaq. There is some overlap between the two indexes, but they are not the same and will, therefore, have different returns.
What’s more, the three BMO ETFs you mentioned have different characteristics. Let’s look at each one in turn.
The BMO Nasdaq 100 Hedged to CAD Index ETF (ZQQ) trades in Canadian dollars and is currency-hedged to smooth out the impact of changes in the Canada-U.S. exchange rate. Because currency hedging is not exact, the ETF will not track the underlying U.S. index perfectly.
The BMO Nasdaq 100 Equity Index ETF (ZNQ) also trades in Canadian dollars but, unlike ZQQ, is not currency-hedged. That helps to explain why ZNQ lagged ZQQ on Aug. 23, a day when the Canadian dollar surged more than half a cent vs. the U.S. dollar. When the loonie rises, the value of U.S. assets priced in Canadian dollars falls, all else being equal.
Finally, the BMO Nasdaq Equity Index ETF (ZNQ.U) is the U.S. dollar version of ZNQ, and one would expect it to have the lowest tracking error of the three vs. the index, given that there are no currency fluctuations or hedging errors introduced into the mix. That has indeed been the case: For the 12 months to July 31, ZNQ.U posted a total return, including dividends, of 23.3 per cent, which is virtually identical to the total return of about 23.9 per cent for the Nasdaq-100 Index. Most of the difference can be explained by ZNQ.U’s management expense ratio of 0.4 per cent.
By comparison, the currency-hedged ZQQ returned about 21.9 per cent over the past 12 months, lagging the index by a couple of percentage points.
But the big winner, by far, over the past year was the non-hedged ZNQ, which posted a total return of about 29.1 per cent, handily beating the Nasdaq-100 Index. ZNQ’s outperformance reflects the fact that the Canadian dollar skidded by more than three full cents vs. the U.S. dollar over the 12-month period, boosting the value U.S. assets priced in Canadian dollars.
Currency movements are notoriously difficult to predict. If you’re having trouble deciding between a hedged or non-hedged ETF, one option is to split your money equally between the two. That way, one of your ETFs will benefit if the loonie falls, and the other will be at least partly protected if the loonie rises.
In my own accounts, however, I prefer not to hedge my U.S. exposure because holding U.S. assets has diversification benefits that help to control portfolio volatility. During periods of financial turmoil, in particular, the U.S. dollar is often seen as a safe haven, but the benefits of a rise in the U.S. dollar will be lost or diminished if one’s U.S. exposure is hedged.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.