Archive | Taxes

Which Bond ETF Is Most Tax-Efficient?

Back in September, my colleague Justin Bender and I published a white paper entitled After-Tax Returns: How to estimate the impact of taxes on ETF performance. Justin has now updated his Excel calculator and made it available for free download on his blog.

Recently Justin put his own methodology to work by measuring the 2014 after-tax returns of 10 short-term bond ETFs. As it happens, 2014 was a relatively good year for short-term bonds: as interest rates fell again, ETFs in this asset class delivered returns between 2.3% and 3.5%. But as we have written about before, traditional fixed income ETFs tend to be full of premium bonds, which are notoriously tax-inefficient because of their high coupons. If you held one of these ETFs in a non-registered account, your after-tax return would have been lower.

Launched in 2013, the First Asset 1-5 Year Laddered Government Strip Bond (BXF) was designed to be a tax-friendly alternative. Strip bonds do not make interest payments like traditional bonds do: rather, they are sold at a discount and mature at par value.

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Taxable Consequences of Norbert’s Gambit

Norbert’s gambit with the Horizons US Dollar Currency ETF (DLR/DLR.U) is often the most cost-efficient way to convert Canadian dollars to US dollars, or vice-versa. Our series of white papers focused on performing the gambit in an RRSP, but if you’re swapping currencies in a non-registered account, you should be aware that it can have tax consequences.

At brokerages such as RBC Direct and BMO InvestorLine, you can place the buy and sell trades within minutes of each other. But several other brokerages do not allow you to journal the ETF from the Canadian side of your account to the US side (or the other way around) until the buy trade settles. In both cases, however, there will be at least three business days for the transaction to be complete, and the US-Canadian exchange rate can move significantly during that time. A big swing could stick you with a capital gain or loss when you make the sale.

What’s more, calculating this gain or loss can be tricky, because both the purchase and sale need to be reported in Canadian dollars. That means any transaction in DLR.U needs to be converted from US dollars.

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The Wrong Way to Think About Withholding Taxes

If you live in a big city, you can save a few cents per litre on gas by travelling to the boonies. But you also understand that it doesn’t make sense to burn $10 of fuel driving out of town so you can save $8 on a fill-up. Yet many investors seem to be making a similar error by trying to avoid foreign withholding taxes in their registered portfolios.

About a year ago, Justin Bender and I co-wrote a white paper that estimated the cost of foreign withholding taxes. There are far too many details to review here, but among the most important is that withholding taxes on dividends are lost if you hold a Canadian mutual fund or ETF of foreign stocks inside an RRSP or TFSA. If you hold the same fund in a non-registered account, however, you can recover the withholding taxes by claiming a credit on your tax return.

Sometimes I feel like we created a monster with this paper, because I have received many e-mails from readers who have misunderstood this information and made poor decisions as a result.

Here’s an example: Cyril wants to build a balanced portfolio that includes US and international equities,

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Tracking Error on International Funds

I recently received an email from a reader, J.W., who wanted to know why the tracking error on some popular Vanguard international equity ETFs were so high in 2014. He noted, for example, that the Vanguard FTSE Developed ex North America (VDU) lagged its benchmark index by 1.62% last year, far more than one would expect.

An index fund’s tracking error is the difference between the performance of the fund itself and that of its benchmark. If the index returns 10% on the year and the fund delivers 9.8%, the tracking error is 0.20%, or 20 basis points. But what could possibly cause a fund to show a tracking error of 162 basis points?

Any time you see a surprising number like this, it’s important to determine the reason: otherwise you risk making a bad decision because you’re working with inaccurate or misleading information. If an index were to lag its benchmark by more than 1.6% because it was badly managed, then you should look for a better alternative. But Vanguard has a long record of tight tracking error, so something else has to be going on here—and indeed it is.

Back on track

To understand VDU’s large tracking error—and why it’s not as bad as it looks—let’s look at the reasons its performance deviated so far from the index.

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The Couch Potato Goes Abroad

Andrew Hallam’s Millionaire Teacher remains one of the best introductions to index investing. When I reviewed it three years ago, I stressed that Andrew writes with authority because he follows his own advice.

In his new book, The Global Expatriate’s Guide to Investing, Andrew shares more of his first-hand knowledge about managing an indexed portfolio outside your home country. Andrew left Canada in 2003 and spent years as a teacher in Singapore before settling (at least for now) in Mexico earlier this year. So he knows all about the challenges—and the surprising benefits—of being an expat investor.

Most of his book’s advice applies equally to homebodies: the first several chapters lay out the case for using a passive strategy, whether with plain-vanilla ETFs, a fundamental index strategy, or the Permanent Portfolio. Then he explains how expats can put these ideas into practice. I asked Andrew to elaborate on some of the key points for Canadians living abroad.

What are the most important tax issues that Canadian expat investors need to be aware of?

AH: So much depends on where the expat is living.

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Ask the Spud: Bond ETFs in Taxable Accounts

Q: Can you share your thoughts about the BMO Discount Bond (ZDB) and the Horizons Canadian Select Universe Bond (HBB) as long-term holdings in a taxable account? – D. F.

Earlier this year BMO and Horizons both launched bond ETFs specifically designed for taxable accounts. These two funds have very different structures, and each has its strengths and weaknesses. So let’s dig more deeply into each fund to help you decide which might be right for your portfolio.

Before we discuss these specific funds, let’s review the problem with holding traditional bond ETFs in non-registered accounts. Most bonds these days trade at a premium (higher than their par value), because they were issued when interest rates were higher. Premium bonds are perfectly fine in your RRSP or TFSA, but they are notoriously tax-inefficient and should not be held in non-registered accounts.

 Do you want a discount or a swap?

The BMO Discount Bond (ZDB), launched in February, is similar to traditional broad-market bond ETFs, such as the iShares Canadian Universe Bond (XBB), the Vanguard Canadian Aggregate Bond (VAB) and the BMO Aggregate Bond (ZAG).

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Tax Loss Harvesting Revisited

No one likes to see their investments plummet in value, but it’s going to happen many times over your lifetime. If you’ve got a strategy for tax loss selling, you can make the best of the situation by harvesting capital losses that can be used to offset capital gains. That gives you an opportunity to reduce or defer taxes in the future, or even recover taxes you paid in past.

In a blog post on September 26, I noted that Canadian equities had fallen by about 5% since the beginning of the month, which could have triggered one such opportunity. (A useful rule of thumb, courtesy of Larry Swedroe, says a security should be sold when the loss is at least 5% and at least $5,000.) If you had recently made a large purchase of the Vanguard FTSE Canada All Cap (VCN), for example, you might have sold it that week to realize a capital loss and then repurchased the iShares Core S&P/TSX Capped Composite (XIC) or a comparable fund. As long as the replacement ETF tracks a different index you’ll maintain your exposure to Canadian stocks while also steering clear of the superficial loss rule.

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After-Tax Returns on Canadian ETFs

When you invest in a non-registered account, you need to be concerned about more than just your funds’ performance: you also need to know how much of your return will be eaten up by taxes. Unfortunately, while regulators are strict about the way ETFs and mutual funds report performance, fund companies in Canada have no obligation to estimate after-tax returns—something that’s been required in the US since 2001.

To help address this problem, Justin Bender spent the last several months creating a calculator for estimating the after-tax returns on Canadian ETFs. He was inspired by Morningstar’s US methodology, but he made many significant changes to adapt it for Canada. The new methodology is fully explained in our latest white paper, After-Tax Returns: How to estimate the impact of taxes on ETF performance. We have also made our spreadsheet available for free download so DIY investors can experiment on their own. (The spreadsheet is protected so the formulas cannot be altered. However, we have included detailed descriptions of these formulas in the appendix to the white paper.)

The methodology is quite complex, but here’s an overview in plain English:

We begin by recording the ex-dividend dates for all the cash distributions an ETF made during the period being considered.

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Foreign Withholding Taxes in International Equity ETFs

It seems Canadian ETF providers are paying more attention to foreign withholding taxes these days. Not so long ago, you rarely heard anyone discussing this hidden drag on returns. But last month BlackRock announced a significant change to its iShares Core MSCI EAFE IMI Index ETF, ticker symbol XEF, which makes up the international equity component of my Global Couch Potato portfolio. The change was made specifically to reduce the impact of foreign withholding taxes.

When the fund was launched in April 2013 it simply held a US-listed ETF, the iShares Core MSCI EAFE (IEFA). That was a convenient way of getting exposure to the 2,500 or so stocks in this large index. Over the last three weeks, however, XEF has gradually bought up the individual stocks in the index and now holds them directly. According to BlackRock:

“XEF will generally no longer be subject to U.S. withholding taxes. While foreign withholding taxes will continue to apply to dividends paid on certain international equity securities included in the XEF Index, it is expected that the change in investment strategy implementation will reduce the overall amount of withholding taxes borne directly or indirectly by XEF.”

A refresher course on foreign withholding taxes

A few words of explanation will help here.

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