PRIIPs require fund providers (including ETFs) to produce a Key Information Document (KID) that enables investors to compare the risks, rewards and costs of different investment products.
European-domiciled UCITS ETFs were ready with their new KIDs when PRIIPs came into force alongside the MiFID II rules at the beginning of 2018. However US-domiciled ETFs did not comply and, as they mostly serve the US market, producing EU-approved information at their own cost is not a priority.
If you already own a US-domiciled ETF then you can hold or sell it but you won’t be able to buy more until a PRIIPs compatible KID becomes available.
Did you know? The US ETF market began in 1993 with the launch of the first modern ETF – the S&P 500 Trust ETF (or SPY). SPY is still one of the largest ETFs in the world today.
Sophisticated ETF investors
A potential exception exists if your platform allows so-called sophisticated investors to buy US-domiciled ETFs. You may qualify if you can demonstrate that you are a professional investor, or are otherwise highly qualified, with the knowledge and experience to understand the risks of the product.Qualification under this exception depends on your broker deciding that you meet the UK definition of a sophisticated investor. You may also need a very large portfolio (over £500,000). Many popular brokers don’t even allow for this workaround so it’s no magic bullet.
A fluid situation
Each European territory implements PRIIPs according to its own interpretation of the standard, so it is possible that some EU-based brokers open to UK investors will make US-domiciled ETFs available under a less strict regime.Moreover, some specialised US ETFs gain up to a third of their assets from large institutional and high-net-worth individual European investors, so they could yet produce compliant KIDs. That said, institutions and wealthy investors are sophisticated investor groups that are not affected by PRIIP requirements.
Even if the blocks on US-domiciled ETFs are cleared, there are numerous other pitfalls to watch out for, including:
- Higher bid-offer spreads
- Foreign exchange (FX) costs
- Extra taxes
- Additional regulations
- Legal issues
Higher trading costs
Dealing in US-domiciled ETFs can incur high bid-offer spreads when your broker places your order with a market maker rather than directly with a US stock exchange. A market maker is a financial middleman that holds a large inventory of securities and saves a broker the trouble of establishing a direct relationship with an overseas market. The market maker takes their profit and covers their risk from the bid-offer spread (the difference between the buying and selling price of the security) which will usually be marked up in comparison to a trade on the exchange.Some brokers do have established partners in the US who can place orders directly on the US exchanges. This is a cheaper arrangement but sadly rare as few brokers have this facility in place.
Uncompetitive foreign exchange costs
US-domiciled ETFs are bought and sold in US dollars. Therefore your pounds must be converted into dollars every time you trade. Most brokers charge a hefty FX rate that’s considerably higher than the real interbank exchange rate. That’s layered on top of the ETF dealing fee you’d normally pay, which may be more than the fee charged for a standard trade on the London Stock Exchange.Bear in mind that these extra costs can quickly mount and take a large bite out of your overall returns.
Did you know? You can recognise a US-domiciled ETF by its ISIN number. This twelve digit code uniquely identifies an individual security and the first two letters reveal its country of origin. The ISIN numbers of US-domiciled ETFs begin with the letters ‘US’. This shows the fund is listed on a US stock exchange and is subject to US legislation.
The burden of regulation
ETFs are tightly regulated because of the ‘F’ in ETF, which stands for ‘Fund’. As a fund, ETFs are rightly considered to be a retail investor friendly product rather than a speculative trading instrument.That means an extensive registration process exists to protect European and US investors - but the two systems are completely different. The net result is that there is not a single fund or ETF registered on both sides of the Atlantic.
The consumer-friendly EU rules that apply to ETFs listed on European stock exchanges are called UCITS. Non-UCITS funds are regulated as Alternative Investment Funds (AIFs). AIFs that are run by non-EEA (European Economic Area) managers must not be marketed in the EU, and that includes US-domiciled ETFs.
Your broker will therefore only provide the bare minimum of information on US-domiciled ETFs. You’ll need to dig into US sources to get anywhere near the level of detail you’d expect to see on a European ETF.
Legal issues
When your investment contributions are held by US institutions then, of course, those institutions are subject to US law. Should something go wrong then your claim on your money or investments will be settled in the US. Investor protections are strong in the US but the process may be lengthy and expensive from a legal perspective.Extra taxes
UK investors are automatically hit by a 30% withholding tax on dividends and interest paid by US-domiciled ETFs. You can cut this tax to 15% if you periodically complete a W8-BEN form for your broker. You can even offset that 15% against the rest of your UK dividend income tax bill.Some SIPPs are withholding tax-free but only if your broker has qualified for an exemption from the US tax authorities. ISAs can’t protect you, however, because they are generally barred from holding US-domiciled funds.
Also, beware of non-reporting funds. These offshore funds have capital gains taxed at income tax rates instead of the more benign capital gains tax rates. European-domiciled ETFS usually have reporting fund status and are taxed normally whereas many US-domiciled ETFs count as non-reporting.
More cons than pros
Trading US-domiciled ETFs is complex, costly and subject to uncertain and changeable regulation on both sides of the Atlantic. This can be difficult for retail investors to keep up with and many who previously bought into US ETFs now find they cannot add to their holdings.The slightly cheaper expense ratios of some US-domiciled ETFs don’t look quite so bright when you account for the hidden costs, and the hazy future returns of a cannabis ETF may prove to be all smoke and no poke. In any case, successful US trends usually don’t take very long to arrive on European shores. The Robotics ETFs from iShares and ETF Securities are good examples which have raised around £ 2.5 billion combined from European investors.
Ultimately, the benefits of US-domiciled ETFs are questionable when Europeans also enjoy diverse choice, liquid markets and low fees.
You can find detailed data on popular trends such as cyber security or sustainability through justETF search safe in the knowledge that we only show UCITS-protected, European-domiciled ETFs.
justETF jargon buster
- PRIIPs – Packaged Retail Investment and Insurance Products
- MiFID II – Markets in Financial Instruments Directive II
- KID – Key Information Document
- UCITS – Undertakings for Collective Investment in Transferable Securities
- ISIN – International Securities Identification Number
- AIFs – Alternative Investment Funds
- EEA – European Economic Area
