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Any move to diversify into foreign markets can be a challenge for investors who use exchange-traded funds.

A fair amount of work is required to go through the ever expanding number of U.S.- and Canadian-listed ETFs tracking foreign markets (with or without currency hedging). Some major pitfalls lurk for lapses in due diligence. Let's try to sort it out.

For long-term horizons, ETFs (U.S. or Canadian) without currency hedging are best, going by studies that show currency fluctuations enhance diversification without sacrificing returns over the long run. I would add that if the Canadian dollar is at historically high levels when an unhedged ETF is purchased, the currency factor could add to returns.

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ETFs without hedging are also better because the costs of currency hedging are a drag on ETF returns. They bump up management expense ratios (MERs) a bit and create a "tracking error" that can shave one to three percentage points off annual returns, as MoneySense blogger Ram Balakrishnan has found in the case of the iShares S&P 500 Index ETF (CAD-Hedged), ticker XSP. (Read it online.)

In the short term, however, currency changes inject uncertainty into returns, so "a shorter time horizon warrants currency hedging if spending is in Canadian dollars," says Ioulia Tretiakova, an ETF expert at PUR Investing Inc. A currency-hedged ETF would make sense, for example, when a person is close to retiring in Canada.

Long-term investors are thus left with two main choices. On the one hand, there are U.S.-listed ETFs, such as the Vanguard Total Stock Market ETF, which covers the U.S. market (VTI). On the other, there are the unhedged Canadian-listed ETFs tracking foreign securities, such as the unhedged version of the iShares S&P 500 Index ETF, (XUS).

Note that U.S.-listed ETFs require currency conversions costing about 1.5 per cent a trade in Canadian-dollar brokerage accounts. This penalizes returns but it can be largely avoided with a technique known as Norbert's Gambit (which involves buying an inter-listed stock in Canada and selling it immediately on a U.S. exchange).

Another ETF expert, Justin Bender of PWL Capital Inc., says unhedged Canadian ETFs are fine for investors who don't want the fuss of currency conversions. But, in general, he prefers U.S.-listed ETFs from the Vanguard Group (in conjunction with the Norbert's Gambit), particularly for registered retirement savings plans.

Vanguard ETFs have MERs that are among the lowest of ETF providers, and offer funds with greater diversification. Also, there are savings to be had on the U.S. withholding tax levied on dividends from U.S.-listed ETFs. The explanation is rather complicated – for more details see a note by Mr. Bender's work associate, Dan Bortolotti.

Investors with a net worth above $5-million (U.S.) are subject to the U.S. estate tax on their U.S.-listed ETFs. For them, Ms. Tretiakova suggests Canadian-listed ETFs tracking foreign securities. In taxable accounts, she would use the HXS Horizons S&P 500 Index ETF (HXS.U), for example. Not only does it dodge the U.S. estate tax but it reduces tax by using a financial transaction called a "total-return structured swap" to effectively convert income distributions into capital gains.

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Larry MacDonald is an Ottawa-based financial writer.

John Heinzl will return.

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