Are Canadian CDRs a good investment?
This post describes what CDRs are and whether they are good for Canadian investors.
What are CDRs?
Canadian Depository Receipts (“CDRs”) were introduced by CIBC as an alternative way for Canadian investors to hold certain US listed stocks. CDRs work in a similar way to American Depository Receipts (“ADRs”). Whereas ADRs make foreign stocks tradable on American exchanges, CDRs make US stocks tradable on Canadian exchanges.
Each CDR share represents a fractional share of a US company, except CDRs are traded on Canadian stock exchanges, in Canadian dollars.
What are the benefits of CDRs?
CDRs have two main benefits:
- Fractional Ownership
- Currency Hedging
First, CDRs allow investors to purchase fractions of shares. For example, if each share of Netflix is trading at $275 USD per share. Each Netflix CDR might represent 1/20th of a share for $18 CAD (after considering the value of each base currency). Fractional ownership might be helpful to some small investors who cannot afford to buy a whole share.
But frankly, if an investor can’t afford to invest more than a few hundred dollars for a single whole share, they should probably avoid investing in individual stocks altogether. With this in mind, fractional ownership should not be a benefit worth considering when thinking about CDRs.
Also, brokerages such as Wealthsimple allow Canadian investors to purchase fractional shares already. Wealthsimple allows for the purchase fractions of a share representing a minimum of $1 dollar in many stocks including those listed in both Canada and the US. So, if you’re a small or beginning investor, you may want to consider using a broker like Wealthsimple before using CDRs.
A second benefit to using CDRs is each CDR is “currency hedged”. With CDRs, Canadian investors can avoid making foreign exchange transactions with their associated fees. CDRs can be purchased with Canadian dollars on Canadian exchanges.
With CDRs, CIBC as the sponsor/issuer will dynamically hedge the foreign exchange price fluctuations between the US and Canadian dollar values. This means CDR investors can separate the value of the underlying stock from the changes in value between the US and Canadian dollar.
But like fractional ownership, the benefits of using CDRs for their currency hedging benefits is overblown. Investors should wonder whether the value of the US dollar is a risk that needs to be hedged at all or whether Canadian investors are better off accepting this risk instead. Since, during economic downturns, the US dollar typically gains in value (for a variety of reasons). This natural hedge provides Canadian investors with diversification and a cushion during downturns. Canadian investors should wonder whether holding some investments in US dollars is a benefit they would want to protect against?
The one-time foreign exchange fee is a small price to pay if you plan to hold a US stock for the long-run.
While fractional ownership and currency hedging might not be benefits worth paying for. Canadian investors should also pay close attention to other costs of using CDRs.
What are the costs of CDRs?
- Currency Hedging Costs
- Trading Fees (liquidity, bid/ask spreads)
- Some “out of pocket” expenses
While CDRs do not have any ongoing management fees, CIBC as the issuer/sponsor of CDRs earns revenue for providing the currency hedging feature. The FX forward rate used for the notional currency hedge will on average have a spread of less than 0.50% per year according to CIBC’s website.
CIBC is entitled to adjust the CDR Ratio to compensate CIBC for actual out-of-pocket costs and expenses incurred in connection with non-ordinary Corporate Actions (such as distributions or exchanges of securities upon a merger event or spin-off transaction), but the amount of such costs and expenses will not exceed 0.10% of the aggregate value of the CDRs of the relevant series according to CIBC.
Unlike ETFs, CDRs don’t have ongoing management fees. Although there are more subtle embedded fees that are more difficult for investors to understand. And, judging by the proliferation of CDRs being issued, we should presume the product is profitable for CIBC and the costs are therefore a drag for investors.
A hidden cost of using CDRs is their liquidity as represented by the bid/ask spread. Each time an investor places a market order, they pay for the difference between the highest price other investors are willing to buy and the lowest price other investors are willing to sell.
At the time of writing, there is a 1 cent difference between bids and asks for Apple Inc trading on the NASDAQ. Compared to 5 cents on the Apple CDR. Based on their respective share prices, this represents an embedded trading fee of 0.0076% for the US listed stock and 0.25% for the CDR. This means the ADR is more than 32 times more expensive to trade based on their bid/ask spreads (even though the overall amount is less than 1% per transaction).
CDRs carry another hidden embedded cost. The foreign exchange fee applied to dividends received. CDRs tout the benefits of receiving dividends in Canadian dollars, but once again there is a cost to this benefit. Each time a dividend in US dollars is paid, the dividend is converted to Canadian dollars by CIBC and then paid out to CDR holders. This means each time a dividend is paid, a small percentage (maybe anywhere from 0.10% to 0.50% according to CIBC’s website) is taken by CIBC for the FX service.
How do these fees compare to using low cost index funds?
Compared to some low cost index funds, CDRs are more expensive. According to my post about low cost index funds, the fees associated with CDRs are much higher. Canadian investors can find many index ETFs with fees under 0.10%. Whereas based on the information provided by CIBC on their website, the cost of CDRs may be as high as 0.60% annually.
With these types of ongoing fees, it won’t take long for CDR investors to be paying more than the one-time foreign currency exchange fees associated with holding US listed stocks directly.
Corporate Governance (voting)
A minor concern for CDR investors is corporate governance. When investors hold US listed stocks directly. They are entitled to vote as shareholders. But when investors hold CDRs, there is another layer between themselves and the company they own. This adds a small complication to the corporate governance and voting process.
What about spin-offs and corporate re-organizations?
When a company experiences a share split or corporate re-organization, CDR shareholders will receive the same outcome. The beneficial tax and ownership circumstances will virtually flow through to the CDR holder as it is designed. But, doing so might also bring with it the same costs the investor was trying to avoid in the first place by using the CDR.
Let’s say Pfizer decides to spin out another company like Viatris in the future. Pfizer CDR holders would presumably receive shares in the spun-out company listed on the US exchange to their Canadian brokerage account. Now the CDR investor holds shares in exactly the thing they were trying to avoid in the first place: a US listed stock denominated in US dollars. When the investor sells this stock, they are tagged with the same foreign exchange fees they used the CDR to avoid.
Dividend Tax
An important tax consideration for Canadian investors using CDRs is the treatment of the US withholding tax. Under the tax treaty between Canada and the US, Canadians get credit for the tax paid on dividends from US listed companies withheld at source by the IRS. This ensures Canadian investors in US stocks are not doubled taxed on their dividends.
To avoid this withholding tax, Canadian non-taxable investors (such as registered charities) can file a W-8 form in certain cases. And, US dividends received within registered accounts such as RSPs & RIFs are not subject to the withholding tax on US dividends either (not TFSAs though) by way of the tax treaty.
According to CIBC, CDR investors will have their US dividend tax withheld at source and receive the net amount. So, investors holding CDRs in registered accounts should be careful and file a W-8 to avoid this requirement.
Foreign Income Verification Statement (T1135)
Yes, CDRs will be considered “specified foreign property” for purposes of the Canadian specified foreign property reporting rules. T1135 reporting in Canada would be required for an investor that is a taxpayer resident in Canada and whose cost of CDRs, plus the cost of any other specified foreign property, exceeds $100,000.
Estate Planning
A key consideration for Canadian investors using CDRs is whether CDRs are still considered “US situated property”.
According to CIBC, “the application of U.S. federal estate tax to CDR holders is dependent on an individual’s particular circumstances and CIBC does not provide tax advice. As such, CDR holders should consult their own tax advisors regarding the U.S. federal estate tax consequences of investing in the CDRs.”
It is unclear whether a CDR is Canadian, or US situated property for estate tax purposes. Investors who might otherwise have US estate tax liabilities after considering their CDRs might want to choose another vehicle (such as a Canadian based corporation) to hold their US stocks and avoid CDRs altogether for this reason.
Conclusion
The costs and complexities of CDRs issued by CIBC make them unsuitable for most investors. The benefits of fractional share ownership can be achieved in other ways including the use of brokers already offering fractional ownership on many more shares.
Comparing the one-time cost of exchanging Canadian for US dollars is far lower than the on-going fees embedded within CDRs.
Costs are a key consideration for investors as the fees that investors pay represent a large drag on returns. Investors should continuously search for ways to reduce their costs while still achieving their investment objectives.
The best way to reduce your cost of investing usually starts by reducing the layers of management and structure between you (the investor) and the productive asset you own.
Complicated investments with lots of layers of management tend to be the most expensive. While simple investments held directly by you tend to be the cheapest.
CDRs represent another layer of fees between you and your investment.
Direct Comparison
Let’s compare holding Apple Shares directly to using an Apple CDR.
Suppose you’re a Canadian investor without US dollars and you want to hold shares in Apple Inc. Your choices are either to exchange some Canadian dollars for US dollars and then purchase shares of Apple in your brokerage account or to use the Apple CDR.
If you exchange Canadian dollars for US dollars, you’ll pay a FX fee of around 1%. On a $1,000 investment this represents $10 and on a $100,000 investment this represents $1,000. The transaction fees associated with buying shares of Apple directly also include the brokerage commission (either something like $9.00 at a typical bank owned discount brokerage or free at places like Wealthsimple or TD Easy Trade) and the bid/ask spread (which in Apple’s case is a small fraction of 1%).
All in, the investment directly into Apple shares trading on a US exchange in US dollars might cost $20 for a $1,000 investment, and $2,000 for a $100,000 investment to execute. That’s it. There will be no other fees associated with holding your Apple shares. If decades go by during this time, these savings could be significant.
Alternatively, a Canadian investor could use the Apple CDR. This would mean no upfront FX fees and the same brokerage fees and bid/ask spreads. But, using the CDR would also mean paying ongoing currency hedging fees which may cost up to 0.50% per year. Over the course of 10 years, these fees may add up to over 5% of the investment’s value. On $1,000 this might mean an extra $50, on $100,000 this might mean an extra $5,000.
So if you plan to hold your US stock directly over more than a few years, then using a CDR might be many times more expensive.
After considering the additional fees, the added complexity of CDRs, and the dubious benefits of both fractional ownership and currency hedging, most Canadian investors should avoid using CDRs on US stocks. If you can “stomach” the benefits of a rising US dollar in tough times, then holding US stocks directly in is the best choice.
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