Archive | October, 2013

Making Smarter Asset Location Decisions

Last week’s posts about tax loss selling prompted some interesting questions about asset location in the comments section. Holding your ETFs and index funds in the most tax-efficient accounts can have a big impact on your long-term returns. But although it’s often easy to set up a portfolio with proper asset location, it can be a challenge to maintain the right balance when you add new money.

Say you’re using the Global Couch Potato portfolio spread across three accounts. Your TFSA and RRSP are maxed out at $25,000 and $125,000, respectively, and you have another $75,000 in a non-registered account. Your optimal asset location might look like this:

So far, so good. But now you’ve won second prize in a beauty contest and received a $25,000 windfall. Since you can’t add it to your tax-sheltered savings, you put the money in your non-registered account. Then you enter the new values into your rebalancing spreadsheet and discover your portfolio is now off its target:

The naive way to rebalance your portfolio would be to make all the transactions in your non-registered account.

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Finding the Perfect Pair for Tax Loss Selling

If you’re using ETFs in a non-registered account, there’s plenty of opportunity to harvest capital losses and reduce your tax bill. Justin Bender and I tell you exactly how to do this in our new white paper, Tax Loss Selling: Using Canadian-listed ETFs to defer taxes on capital gains.

As I explained in my previous post, tax loss selling involves dumping an ETF that has declined in value to crystallize the loss, and then buying a similar (but not identical) ETF to maintain the exposure in your portfolio. The Canada Revenue Agency considers any two index funds tracking the same benchmark to be identical property. So you cannot, for example, claim a loss after selling the iShares S&P 500 (XUS) and replacing it with the Vanguard S&P 500 (VFV): if you do, it will be denied as a superficial loss.

Fortunately this year has seen a number of new ETF launches, including international equity ETFs from iShares and Canadian and US equity ETFs from Vanguard. These give Canadians much better options when tax loss selling,

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Tax Loss Selling with Canadian ETFs

Traditional equity index funds are often touted for the tax-efficiency of their structure, and rightly so. But there’s another potential tax advantage that few ETF investors employ. Justin Bender and I explain the details in our brand new white paper, Tax Loss Selling: Using Canadian-listed ETFs to defer taxes on capital gains.

Tax loss selling is a technique for harvesting capital losses in non-registered accounts so they can be used to offset capital gains incurred elsewhere. Suppose you hold $50,000 worth of a Canadian equity ETF and its value declines to $45,000. By selling your shares, you can crystallize a capital loss of $5,000. And by claiming that loss, you may be able to offset a $5,000 capital gain elsewhere in your portfolio, potentially deferring hundreds of dollars in taxes.

When you file your tax return, any capital losses must first be used to offset gains you’ve incurred in the current tax year. Any remaining losses can be carried back up to three years, or carried forward indefinitely to offset future capital gains. (To carry back current capital losses to prior years, you need to file form T1A – Request For Loss Carryback with your return.)

The problem with realizing a capital loss is that it can mean selling a security that plays an important role in your portfolio.

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More Swap-Based ETFs on the Horizon

I have to admit I was skeptical when the Horizons S&P/TSX 60 (HXT) appeared back in September 2010. In an interview with a Horizons executive a few months later, I asked why the company would go head-to-head against the iShares S&P/TSX 60 (XIU), the largest ETF in the country.

It turns out HXT has become an extremely successful fund. Not only for Horizons’ bottom line (the fund now has close to $1 billion in assets and is the largest non-iShares ETF in the country), but for investors as well. As of September 30, its three-year annualized return was 3.75%, compared with 3.81% for the S&P/TSX 60 Index. As tracking errors go, 0.06% is about as good as it gets. Over the same period, the venerable XIU returned 3.59% for an annual tracking error of 0.22%.

Swapping returns

HXT tracks its benchmark so tightly because it uses a total return swap: rather than holding the underlying stocks in the index, the fund has an agreement with a counterparty—in this case, National Bank of Canada—who agrees to deliver the full return of the S&P/TSX 60,

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More DIY Investing Challenges

In my last post, I looked at some of the biggest challenges faced by DIY investors. I came up with the list after working with clients of PWL Capital’s DIY Investor Service. The theory behind indexing is relatively straightforward, and it’s quite easy to set up a simple portfolio. But do-it-yourselfers often face obstacles when trying to implement their plan. Here are a few more that need to be overcome if you want to be a successful DIYer.

Unrealistic expectations. Anyone who works with an advisor completes a risk tolerance questionnaire, and the process is revealing. Investors often say they want an expected return of 6% to 7% (occasionally we get people who expect 8% or more) while also indicating they’ll accept no more than a 10% loss in any given year. Those goals are incompatible.

With bond yields under 3% today, a balanced portfolio of 60% equities and 40% fixed income probably has an expected return of about 5% before fees, and in a scenario like 2008–09 it could suffer a drawdown close to 20%. Unless investors understand these trade-offs they can’t hope to carry out a long-term plan.

Ignoring asset location.

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The Biggest DIY Investing Challenges

At the recent Canadian Personal Finance Conference in Toronto, I participated in a panel discussion that touched on a wide range of investing topics. My co-panelists were Michael James and financial planner Jason Heath, and we were moderated by the esteemed Big Cajun Man. The first question we were asked to address is whether it makes sense to use an advisor or to invest on your own.

That was a tough question to tackle in a room full of committed do-it-yourselfers. It’s also one I’ve struggled to answer honestly in the last couple of years. I’ve been an advocate of DIY investing for some time, and I still believe many investors with uncomplicated situations are capable of managing a simple index fund portfolio on their own. Indeed, I think anyone with less than $100,000 or so should seriously consider doing so, because it’s awfully difficult to find an unbiased, fee-based advisor unless your portfolio is larger. And unfortunately, it’s all too easy to find a commission-based mutual fund salesperson who will turn your wealth into his own.

But over the years, as I’ve corresponded with readers—and more recently started working with clients—I’ve learned that DIY investing is much harder than it sounds.

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