Buying Index Funds – 2 More Options

In the last few weeks, I’ve run across two more options for buying index funds, the key building blocks of my portfolio (and of anybody taking a passive, buy-and-hold, Bogleheads-ish approach). I haven’t implemented either of them yet, but wanted to share what I’ve found and I’d be very interested to hear if any of you have tried one or both.

While this blog is mostly about American citizens in the UK, these options likely apply to Americans in the EU as well.

In short, they are 1. Exercising options and 2. Buying PFICs in an IRA

Quick Background

One of the hurdles for US citizens living in the UK or the EU is the catch-22 of buying ETFs and mutual funds:

  • The US will happily allow you to buy non-US mutual funds or ETFs, but will impose horrific penalties and filing requirements because it’s a PFIC.
  • The UK/EU governments, via the MiFiD/PRIPS rules, will not allow you to buy US mutual funds or ETFs because they don’t give you, the consumer, enough information – they don’t have a Key Information Document.
    • Apparently, US funds can’t provide a KID even if they wanted to – some kind of clash between SEC and EU/UK rules on forward-looking statements.
  • If you, as a UK resident and taxpayer, do manage to actually buy a US fund, as long as it’s on HMRC’s reporting funds list, all is good.
    • I’m not familiar enough with the tax regimes of the 27 EU countries to speak about any parallels they have for PFICs, reporting funds, or any other kind of offshore/foreign investment vehicles.
    • If it’s not on the list, the punishment isn’t as bad as PFICs, but you do pay for any gains at income rates, not the lower capital gains rates.
    • It’s fine to buy stuff not on the list inside a treaty-protected “pension” (e.g. 401k, IRA, etc.).

So how to get around this? There were four options that I was aware of until recently, when I added two more:

  1. Buy within a UK pension (or other treaty-protected “pension”), so that PFIC rules don’t apply
    • Simplest option, probably the core part of the portfolio of most Americans in the UK since you get auto-enrolled, employer match, etc.
    • But there are contribution limits (with some questions around exceeding employer contributions making it a foreign grantor trust), pensions are relatively inflexible vehicles with almost no provisions for early access, and you may or may not have good investment options in your pension – high fees, etc.
  2. Don’t let a US brokerage know that you live outside the US – use a US address (friend, family, etc.)
    • This definitely works and has the least restrictions of anything. I do wonder how sustainable it is for the long term, and you need to decide for yourself if you’re happy lying to your brokerage.
  3. Become an accredited investor, with 2 of:
    • €500k+ to invest
    • A track record of investing, like 10+ decent sized trades a quarter
    • Professional experience in finance
    • This one also definitely works, but not many of us qualify. You can pay an accredited investor to manage your money for you, but I’d rather not pay somebody to do something I can do myself just as well.
  4. Give up on index funds and buy individual stocks
    • This is exactly what I’m doing in my ISA
    • But you lose out on the benefits of indexing – for an ISA’s tax advantages, I’m ok with that. But I’d rather not do it more than I have to, for an IRA or taxable account
  5. New: Buy US ETFs via options
  6. New: Buy EU (mostly Irish) ETFs within a US IRA

In all of these cases, we’re just trying to buy boring, broad index funds – nothing especially complicated, although if you were wanting to buy a triple-leveraged ETF focused on underwater basket-weaving companies, the same processes would work. Sadly, because of the silly interactions of US and UK/EU laws, we’re jumping through hoops to try to buy the simplest world all-cap or S&P 500 index funds.

Option 5: Buying US ETFs via Options

Some warnings before we start:

  1. I’m not trying to make money with options trading – they’re purely a way around the PRIIPS/KID hurdles that prevent UK/EU residents from buying ETFs. I’m not an advocate of options trading for “normal” investors.
  2. You need to make sure that anything you buy in a taxable brokerage account via this method is HMRC reporting. Bogleheads has a useful list of Vanguard ETFs that are also HMRC reporting – I’m not aware of any other good index ETFs that are HMRC reporting (I’ve checked for Schwab, Fidelity, & others, no luck)
  3. Interactive Brokers is not the world’s simplest platform for investing – be careful you know what you’re doing! Spend some time paper trading first.

The basic idea of this option (as described on the Bogleheads forum) is:

  1. Open an account at a US brokerage that has options trading, using your legitimate non-US address. The only brokerage I know of that definitely meets these criteria is Interactive Brokers; Schwab International might as well but I’m not certain.
  2. Shortly (a day or two) before option expiration on the third Friday of every month, buy 1 or more call option contract on the ETF you want to buy – trying to minimize the premium and strike price costs.
  3. Exercise the call option, typically at 16:00 Eastern time on the Friday.
  4. Now you own 100 shares of the ETF per call option.

The big advantage: PRIPS/MiFiD prevents you buying the US ETF directly, but doesn’t prevent you buying options on the US ETF. That’s absurd policy (why is the EU protecting individuals from buying vanilla ETFs but not potentially riskier options on those same ETFs?), but it works. Note that the restriction is only on buying; you should be able to sell the ETF normally, no messing about with options.

A couple disadvantages:

  • Only works once a month – not a huge deal for long-term investing, but a bit annoying
  • You can only buy ETFs in lots of 100 shares. That’s a pretty big chunk of money – VT (world all-cap) is around $100 a share, so you’re investing in $10,000ish increments. The lowest priced HMRC-reporting Vanguard ETF I could find is VEA (Developed Markets excluding US), at about $50 a share, so still in $5,000 chunks.

You can also do a similar transaction by selling put options – slightly lower cost but slightly more uncertainty because you depend on the other party to decide whether or not to exercise the option.

I’ve tried the call option version on Interactive Brokers paper trading and it worked without a hitch – their interface is far from the simplest, but it works (really intended for much more advanced trading than what I want to do!). If I’m fortunate to have excess funds beyond what I invest via my UK pension, ISAs, and IRAs, I’d try this in a taxable account – don’t think I’ll be so lucky anytime soon!

Option 6: Buy EU ETFs in an IRA

By now, many of us probably have “PFICS=bad” pretty much engrained in our mind, with the exception of pensions. But there are really two parts of PFICs that are so bad:

  1. Tax: tax rates can be very punitive – sometimes even exceeding 100% of the gain
  2. Tax returns: the filing requirements are extremely onerous, taking a lot of time and/or money to prepare. Hours and hours per holding per year.

However, holding a PFIC in an IRA prevents both of these – none of this is dependent on the tax treaty, just US law:

  1. Tax: IRAs are tax-deferred (Traditional) or tax-free (Roth) – there’s no tax due on any capital gains, etc. Even for Traditional, you’ll just pay income rates when you eventually withdraw. PFICs don’t create any additional tax inside an IRA.
  2. Tax returns: PFICs inside an IRA don’t require all the painful filings. This is also true for 401k and other tax-advantaged accounts, although finding a 401k that offers a PFIC is pretty unlikely!

So this is a pretty simple option – just open an IRA at a brokerage, using your non-US address, that will allow you to buy non-US funds. Again, Interactive Brokers allows this, possibly Schwab International as well.

There are a few considerations:

  • You’ll probably be primarily looking at EU, mostly Irish, ETFs. These tend to have higher costs than similar US funds, and often track less diverse indices, resulting in less diversity across your portfolio. For example, the US VT ETF (Vanguard Total World Stock) has 9,074 stocks across large, mid, & small caps, for a 0.08% expense ratio. The similar Irish VWRD (Vanguard All World) has 3,618 stocks, only mid and large cap, for a 0.22% expense ratio.
    • You can build an equally diverse portfolio using specialized geographic and/or capitalization-based funds, but it will cost you more. Especially getting into regional small caps the ER goes up considerably – replicating the European part of VT likely takes 3 funds, with the small cap part having a 0.58% ER.
  • If you can help it, you probably want to keep US holdings in US-based funds, to avoid US dividend withholding tax (which I can’t figure out a way to get back, even though we have to file US tax returns!). This is 30% by default, although in Irish ETFs the US/Ireland tax treaty reduces it to 15%.
    • This isn’t a massive effect – if we assume a roughly 2% dividend yield for US stocks, this is 15% of 2%, or about 0.3% for a US-only fund. That said, if we were choosing between two identical index funds and one had an ER of 0.1% and the other 0.4%, I know which one I’d pick!
    • If you still have a 401k or similar, this is a good place for your US holdings. Also, if you have existing US ETFs/mutual funds in an IRA or taxable brokerage, you should be able to continue to hold them, even if you tell your brokerage you’re now living in the UK/EU (as long as they don’t close your account), you just can’t buy any more.
  • Since the investments are inside a treaty-protected IRA, you technically don’t need them to be HMRC reporting, although you’d struggle to find many Irish ETFs that aren’t HMRC reporting even if you tried.

I do find this a really interesting option – there’s no skirting around any rules, you’re being completely open with your brokerage, HMRC, and IRS. The drawbacks of using Irish instead of US ETFs are real but fairly small, and no worse than a non-US citizen resident of the UK/EU faces for their own investments.

Just as an example, moving most of the non-US portion of my overall portfolio to Irish ETFs, with my current asset allocation, would change my overall expense ratio from 0.088% to 0.112%, with little to no impact on diversification. That’s a real impact – 27% more fees! – but it’s still well within what most people would call low fee, and still less than the lowest fees in my relatively good UK pension (0.29% at the cheapest).

I’m planning on trying this with my 2022 IRA contributions, just to make sure it all works smoothly, then may think about moving my IRAs over to Interactive Brokers and doing this completely. There’s no huge rush – using a US address is working fine at my existing brokerage – but it still doesn’t feel like it will work forever and I don’t love the workaround.

Conclusions

While the whole catch-22 situation remains completely absurd and pretty pointless, it’s good to have a few more choices! Have you tried the options or EU ETFs in an IRA routes? How did they work for you? Is there a seventh choice I haven’t found yet?

I’ll report back when I try the Irish ETF path early next year, and if I ever do the options way I’ll write a post on that, too. In the meantime, my UK pension is on autopilot and my IRA and ISA contributions are done for the year, so it’s pretty quiet on the investing front until 2022.

4 thoughts on “Buying Index Funds – 2 More Options

  1. I believe Option 6 used to be possible via a Charles Schwab IRA, with a non-US address, over the telephone only, of a handful of Irish ETFs. However, if I now try going to the “Schwab’s Non-US ETF Center” I get the message:

    Please respond to the statement below to access the funds available through our marketplace.

    If ALL THREE statements are true, please click Yes

    I am not a U.S. resident
    I am not a U.S. person (citizen, permanent resident alien, or entity organized under the laws of the U.S. or any of its jurisdictions)
    I am not physically present in the U.S.
    If you cannot confirm the statement, please click No

    So I suspect this route might not be possible via CS. I’ve not tried calling them to find out. Half the IRA is already in a US ETF (non reporting) from before the Mifid/Priips rules, so I’ll avoid selling shares in this unless eventually forced to.

    I have recently opened an Interactive Brokers account from the UK using a UK address. Something went wrong with the application and so I was left waiting for months being told my approval was pending. After calling them to complain, my account was opened in one day. I have now applied for Mifid “professional” categorisation and that appears to be pending. I might just get approved based on a one-year period where I happened to be moving a bunch of shares around and so I was effectively trading way more than I usually would. They’ve asked for brokerage statements to prove of my activity and account values. I had to just take screenshots because I don’t really get detailed transaction statements. This is all just to prove it’s going to be possible to buy something innocuous like VT… I think this route would only be of use to someone approaching FIRE, by which point they would have already utilised one or more of the other investment options. There’s no way I would ever move all my assets over to them. IBKR is insanely over-complicated and over-featured for a bog-standard buy-and-hold investor, but their trading fees have dropped even lower recently and they appeared to be the only people open to offering this route to offshore US citizens. Unfortunately they’ve also been fined (again) recently for poor anti-money-laundering procedures…

    I don’t really need to be “Mifiid pro” right now, as I’m using your Options 1 & 3. However, I plan to drawdown my SIPP eventually and I don’t really want all my investments in individual shares. I’m hoping to potentially hold this account until at such point I might need it. I suspect once/if I gain professional categorisation that they would not bother checking again to see if I still qualify.

    Liked by 1 person

  2. I think there’s a subtle legal distinction on U.S. Person that most brokers don’t want to deal with – sounds like that includes Schwab at this point. It is a shame that only Interactive Brokers seems willing to deal with the minefield of regulations, and as you say they’re far too complicated for what we’re trying to do. There probably is a niche market for “simple” US citizens not living in the US, but I imagine there probably isn’t much money in it either!

    I’m definitely not comfortable enough with IBKR to move anything like the majority of my US portfolio to them (and can’t move ISA or pension/SIPP, although I’m happy enough with HL and Aviva at this point anyway). Most of my US portfolio is in my Thrift Saving Plan anyway – no desire to move that for decades, but some day far in the future it may make sense to consolidate and roll that into an IRA. The rest is in my existing IRA, thinking I probably don’t want to sell the Vanguard ETFs in there either. So may also just wind up with IBKR for future IRA contributions at this point, which will stay small for some time to come.

    Trying to put it all together just to replicate VT is absolutely a headache. To do as much as possible in UCITS ETFs would be something like:
    TSP: US all-cap equity + US bonds + a little international developed
    Roth IRAs: Europe ex-UK Large + Mid + Small, Japan All Cap, Pacific ex-Japan Large/Mid + Small & Emerging Markets – 7 funds!
    UK Pension & ISAs: UK equity

    It’s all possible, but just way too many accounts and holdings when all I want is VT!

    Liked by 1 person

    1. The only change I can imagine might happen would be a relaxation of the Mifid rules following Brexit, but the FCA are usually in the business of more regulation not less and frankly I don’t think they can less about US citizens in the UK…. Perhaps a US fund will issue a KID? But the Mifid rules do seem to be incompatible with SEC rules…

      Liked by 1 person

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