In an earlier post, we discussed how investing in funds that hedge the exposure to foreign currencies entails a significant cost in terms of a large tracking error. There is a further cost involved in holding these funds: taxes. It is no surprise that currency-neutral funds could generate large taxable distributions – by their very nature, currency contracts are short-term instruments that trigger a taxable event at the time of settlement.
For instance, 11.9% and 37.0% of the returns of the iShares S&P 500 Index Fund (IVV) were in the form of dividends and hence taxable in 2006 and 2007 respectively. In contrast, the iShares CDN S&P 500 Index Fund (XSP) generated taxable distributions of 11.2% and 434% of the returns during the same time period without accounting for the 15% withholding tax on the dividends from its holdings in IVV. The story is similar in the case of iShares MSCI EAFE Index Fund (EFA) (10.0% and 27.5% in taxable dividends in 2006 and 2007) and iShares CDN MSCI EAFE Index Fund (XIN) (12.8% and 238.68% in taxable distributions in 2006 and 2007).
The tax inefficient nature of currency-neutral funds implies that they should be held in tax-deferred accounts. Historically, the currency-neutral funds used to be called “clone” funds that used derivatives to skirt around foreign content restrictions in RRSPs. But even when held in RRSP accounts, these funds have a tax disadvantage – while dividends received from IVV are not taxed, a withholding tax of 15% is paid by XSP on dividends received from IVV. To my knowledge, a Canadian investor holding a currency-neutral fund in a RRSP account cannot recover the withholding tax, which adds another 0.3% (15% of a 2% dividend yield) to the expense of holding these funds.
