UCITS Vs U.S. ETFs - Pros And Cons For Non-US Investors (2024)

ETF Domicile is not very glamour. And something that most new investors won’t pay attention to. While fees and index tracking frequently steal the spotlight, the domicile’s pivotal role in portfolio performance cannot be overstated.

Some of our readers from Latin America, Asia and the Middle East know how to optimise their tax bill.

But here is what most investors ignore, and may pay a heavy price for it.

US ETFs and UCITS ETFs present distinct features, catering to diverse investor needs globally.

• U.S. ETFs – Governed by the SEC, they operate primarily within U.S. markets under the Investment Company Act of 1940 and Securities Act of 1933, offering favorable taxation for U.S. investors. These funds typically distribute income and have greater access to leverage, with fewer restrictions on securities lending.
• UCITS ETFs – regulated by ESMA and compliant with the UCITS Directive (Undertakings in Collective Investments and Transferable Securities), focus on global markets with a significant presence in Europe, also providing tax efficiency for other non-U.S. investors. They have stricter rules regarding securities lending and leverage, and they can either distribute or reinvest income. UCITS ETFs are domiciled mainly in Luxembourg or Ireland, offering a broader global accessibility with currency hedging options and compliance with stringent investor protection and risk diversification standards.

As of August 2023, just over 11% of all ETFs are not domiciled in Europe or the U.S. These include mainly Asia:

• Japan – represents just below 5% of all ETFs
• Asia-Pacific ex-Japan – representing just over 6%, including markets like Australia

Some countries in Latin America, and South-Africa have tiny market shares (<1%) but investors in those countries usually choose U.S. or UCITS ETFs.

Who can ACCESS U.S. AND UCITS etfs?

There are no specific laws prohibiting non-U.S. citizens from investing.

Both the Securities and Exchange Commission and the U.S. government encourage foreign investments in U.S. equities and debt markets to fund the U.S. capital markets and economy.

However, the situation is different for investors in Europe due to regulatory changes. Since 2018, individual investors in the EU have been restricted from investing in U.S. ETFs.

This is due to regulations that require ‘Key Information Documents’ (KIDs) to help them better understand the products they are buying. U.S.-registered ETFs do not contain this document, which led to the restriction on trading U.S.-registered ETFs in Europe.

As European, you can get around this restriction in becoming an elective professional client. There are certain criteria to fulfil, but in practice you must often have €500,000 in your financial portfolio. Alternatively, certain U.S. Brokers may offer access to them.

Investors in Asia, South America, or the Middle East can invest through European products.

UCITS ETFs are listed, amongst others, on Stock Exchanges in Singapore, South Africa, Israel, Saudi Arabia, Brazil, Chile, Mexico or Peru. But non-US Investors can also often access them directly through European Stock Exchanges.

For example, in South Africa investors can access iShares funds through 1NVEST feeder funds.

US ETFs typically exhibit higher liquidity and larger average daily trading volumes, primarily due to the substantial size and depth of the U.S. financial markets.The competitive landscape in the U.S., with numerous market makers and a broad range of sectors and strategies covered, further enhances liquidity and lowers expense ratios through economies of scale.

Conversely, UCITS ETFs, while diverse, face challenges in liquidity and trading volumes due to market fragmentation in Europe. This fragmentation stems from UCITS ETFs being listed on multiple exchanges across various countries, leading to divided market participation and visibility.

Although they offer international accessibility, the expense ratios in UCITS ETFs are generally marginally higher. This can be attributed to operational complexities and costs arising from the need to navigate through the diverse and fragmented European financial markets, as well as the taxation structures inherent to each jurisdiction.

For the most liquid asset classes (S&P 500) differences are minimal while Bonds may have larger discrepancies (difference of 0.22%).

The variety of products available in the U.S. financial markets is superior. The U.S. markets offer a broader selection of Exchange-Traded Funds (ETFs), including an extensive range of factor ETFs that are designed to capture specific risk factors or investment styles, such as value, size, volatility, momentum, and quality.

Niche issuers of factor ETFs in the United States include American Century Investments (Avantis), Dimensional Fund Advisors or Alpha Architect.

In theory, UCITS ETFs have a number of other restrictions, including asset concentration or investment restrictions.

In practice, Europeans also have access to other funds:

• ETC and ETN Funds – that invest in commodities or cryptocurrencies.
• REITs that invest in Real Estate.

Concentration rules are usually not problematic for diversified, long-term investors.

EU nations have streamlined fund regulation with UCITS, enabling a seamless cross-listing of funds and ETFs across member states. But UCITS isn’t just a European sensation—it’s a global trailblazer.

UCITS has become a well-recognized regulation standard for mutual funds and ETFs, and some countries in South and Middle America, as well in Asia, allow UCITS funds to be cross listed and sold to local investors.

There is no other regulatory framework competing with UCITS that allows funds to be distributed globally (other countries have only bilateral agreements).

From a non-U.S. investor’s tax perspective, UCITS ETFs often present a more favourable tax environment compared to US ETFs.

When you invest in US ETFs you may face:

• Higher Withholding Taxes – US ETFs typically incur a 30% withholding tax on dividends, which can sometimes be reduced through tax treaties
• Estate Taxes – US ETFs may also expose non-U.S. investors to U.S. estate taxes and potential capital gains taxes in the U.S.
• Complex Tax Reporting – for US ETFs can also be complex for non-U.S. investors.

Conversely, UCITS ETFs usually enjoy:

• Lower Withholding Taxes – on dividends due to favourable treaties with countries where they are commonly domiciled, like Ireland and Luxembourg.
• No Estate Taxes – They pose no U.S. estate tax exposures
• Simplified Tax Reporting – They offer simplified tax reporting.
• Further Tax Optimisation – With the flexibility of choosing between distributing and accumulating share classes. This structure often results in efficient tax growth and potentially favourable capital gains tax treatment, depending on the investor’s country of residence.

Conversely, the main reason why U.S. Investors might prefer U.S. ETFs is to avoid local tax complications.

Investing in U.S. ETFs allows U.S. investors to avoid the complications and stringent reporting requirements associated with PFIC regulations. U.S.-based ETFs typically offer a more straightforward tax treatment, making them more attractive to U.S. investors.

U.S. ETFs are structured in a way that is compliant with U.S. tax laws, and the tax reporting is more straightforward. The dividends and capital gains from these ETFs are subject to U.S. tax laws, which investors and their tax advisors are usually more familiar with.

It is a rare situation. But there are certain European countries that have protection against US Estate taxes (please verify before investing) and allow investors to buy US ETFs, potentially offsetting withholding taxes against local dividend taxes.

For example, some investors in the UK (assuming you meet the €500k eligibility criterion) and Switzerland may fall into this category. We have a dedicated guide to reducing withholding taxes for Europeans Investors.

Overall impact - For Which Investors is UCITS more advantageous?

There are two cases when UCITS ETFs can be particularly useful:

• For countries without an income tax agreement with the U.S.
• For countries with an income tax agreement but with a weak Estate Tax protection.

• Asia: Singapore, Malaysia or Vietnam.
• Middle East: Oman, Qatar, Saudi Arabia or United Arab Emirates
• South America: Most countries, including Argentina, Brazil and Chile.
• Africa: Almost all countries.
• Europe:Croatia, Liechtenstein, Macedonia, Malta, Monaco, Montenegro, Serbia.

Even with an income tax treaty between the U.S. and another country, non-U.S. investors in U.S. ETFs might still navigate challenges like potential U.S. estate taxes.

US estate taxes begin at just $60,000 of US holding for non-resident aliens and apply at rates of 26-40% of assets above that level without a US estate tax treaty.

Only sixteen countries have estate tax treaties with the US:

• Asia – Japan, Australia.
• Europe – Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Norway, Switzerland and the UK.
• Africa – South Africa

However, not all of them are structured favourably. A poor US estate tax treaty does not increase the US estate tax exemption for non-resident aliens to more than the standard $60,000 amount.

In contrast, investing in UCITS ETFs alleviates these concerns as they’re domiciled outside the U.S., often in jurisdictions like Ireland or Luxembourg, eliminating U.S. estate tax liabilities for foreign investors and, in certain cases, reducing administrative hassles related to U.S. tax documentation and reporting.

Conclusion

In conclusion, while US ETFs generally offer superior liquidity and lower costs due to the vast size and depth of the U.S. financial markets, non-U.S. investors should closely consider UCITS ETFs due to significant tax advantages.The tax benefits of UCITS ETFs, coupled with no U.S. estate tax exposure and simplified tax reporting processes, often outweigh the marginally higher expense ratios they might carry.

But, there could be exceptions. Understand your individual circ*mstances before buying ETFs.

With the continuous growth and development in the UCITS ETF market, the gap in liquidity and investment options compared to US ETFs is narrowing, making UCITS ETFs an increasingly attractive and competitive investment vehicle for international investors.