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How Taxes Can Affect ETF Performance

In our recent white paper, After-Tax Returns, Justin Bender and I introduced a methodology for measuring the effect of income taxes on ETF returns. Justin also created a downloadable spreadsheet you can use to estimate the after-tax returns of funds in your own portfolio.

As we explain in the paper, funds with similar pre-tax returns can look quite different when you compare their performance after the CRA has taken its cut. Remember that on a pre-tax basis investment gains are reported in the same way whether they’re Canadian dividends, fully taxable income or capital gains. If you’re investing in a tax-sheltered account, it’s all the same. But in a non-registered account, distributions are taxed in different ways, and this can dramatically affect the amount of money you actually keep.

Here’s a real-world example that illustrates how large the difference can be. Justin collected the distribution and price data for the iShares Core S&P/TSX Capped Composite (XIC) and the DFA Canadian Core Equity Fund (DFA256) over the nine years ending in 2013. Both funds track the broad Canadian stock market, so you would expect similar returns.

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Is It Time for Tax Loss Selling?

Last October, Justin Bender and I published a white paper on tax loss selling with ETFs. It explained how index investors can harvest capital losses while maintaining a consistent exposure to the equity markets. We were proud of the paper (which was even adapted as a continuing education course for advisors) but it proved to be rather useless during the subsequent year. Indeed, it would have been irrelevant during much of the last three years, as the charging bull market never stopped to catch its breath. There were simply no capital losses to harvest.

Well, it may be time to dust off the paper. September has been a difficult month for stocks, especially in Canada, and investors with large portfolios might now have their first tax-loss selling opportunity since 2011.

No gain, no pain

Let’s start with a refresher on how tax-loss selling works. In a non-registered account, when you a sell a security that has declined in value, you realize a capital loss. You can use these to offset any capital gains you’ve incurred in the current year, which can reduce your tax bill.

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US Investors in Canada: What to Watch For

Index investors in the US have always had it easier than Canadians, thanks to lower costs and more choices. Unfortunately, if those investors move to Canada, their plight becomes much more difficult.

Unlike Canada (and virtually every other western country), the US requires its citizens to file an annual return and potentially pay taxes even if they live abroad. The rules may apply even if you were born in Canada and have never lived in the US, since it’s possible to inherit citizenship from US-born parents. For tax purposes, “US persons” don’t even need to be citizens: they can also be Canadian green card holders or snowbirds.

Tax implications for US persons living in Canada are complex and often controversial: if you’re in this situation, you should seek help from an advisor who specializes in cross-border issues. But here’s a heads-up on two issues that have recently come up with clients of our DIY Investor Service who had no idea they were flirting with danger.

Don’t open a TFSA or an RESP. Tax-Free Savings Accounts (TFSAs) and Registered Education Savings Plans (RESPs) offer significant tax benefits for Canadians.

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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.

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Canadian Couch Potato Threatened By Legal Action

[Note: This post was an April Fool's joke!]

I regret to announce that this blog is in jeopardy of being shut down due to pending legal action.

On the afternoon of Friday, March 29, I received a letter from the law firm of Zuckercorn & Loblaw, LLP. The attorneys informed me that the name “Canadian Couch Potato” is owned by an Ontario corporation that is threatening to sue for trademark infringement. According to the letter: “You can avoid legal action by immediately ceasing and desisting from any and all infringing activity including use of the canadiancouchpotato.com domain.”

The letter gives me seven (7) days to decide on a course of action, and I am currently seeking counsel from my own attorney before determining how to proceed. Rest assured I will not give in unless I have no other choice.

You can read the full text of the cease-and-desist letter by clicking the image below.

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Couch Potato Portfolio Returns for 2012

I think we can safely say we are now almost four years into the most disrespected bull market in history, to borrow a phrase from Alexander Green. In a recent roundtable in The Wall Street Journal, the moderator opened the discussion by saying, “It’s been another very difficult year for investors.” Um, really? US stocks were up over 16% in 2012, and international equities did even better. If that’s a difficult year, I can’t wait for an easy one.

Indeed, last year was much kinder to investors than 2011, when the Complete Couch Potato returned just 2.36% and most of my other model portfolios did worse. In 2012, all of the model portfolios delivered remarkably similar performance, with returns between 8% and 9%.

The data below were gathered from fund websites whenever available: otherwise I used Morningstar. Returns for US-listed funds are expressed in Canadian dollars. Consider these unofficial results: when I have all the necessary data I will update the long-term Couch Potato performance report card. [Note: The updated report card is now available.]

Global Couch Potato (Option 1)

iShares S&P/TSX Capped Composite (XIC)
6.9%

iShares MSCI World (XWD)
13.5%

iShares DEX Universe Bond (XBB)
3.3%

8.1%

Global Couch Potato (Option 2)

TD Canadian Index – e (TDB900)
6.9%

TD US Index – e (TDB902)
12.6%

TD International Index – e (TDB911)
15.5%

TD Canadian Bond Index – e (TDB909)
3.1%

8.2%

Global Couch Potato (Option 3)

RBC Canadian Index (RBF556)
6.4%

RBC US Index (RBF557)
11.8%

RBC International Index (RBF559)
16.4%

TD Canadian Bond Index – I (TDB966)
2.8%

8.0%

Complete Couch Potato

iShares S&P/TSX Capped Composite (XIC)
6.9%

Vanguard Total Stock Market (VTI)
13.4%

Vanguard Total International Stock (VXUS)
15.2%

BMO Equal Weight REITs (ZRE)
18.1%

iShares DEX Real Return Bond (XRB)
2.4%

iShares DEX Universe Bond (XBB)
3.3%

8.7%

Yield-Hungry Couch Potato

iShares S&P/TSX Cdn Div Aristocrats (CDZ)
9.0%

iShares DJ Canada Select Dividend (XDV)
8.8%

iShares Global Monthly Adv Dividend (CYH)
9.5%

BMO Equal Weight REITs (ZRE)
18.1%

iShares S&P/TSX Preferred Stock (XPF)
11.1%

iShares DEX HYBrid Bond (XHB)
8.7%

iShares Advantaged US High-Yield Bond (CHB)
13.0%

iShares Advantaged Canadian Bond (CAB)
3.0%

8.5%

Über-Tuber

iShares Canadian Fundamental (CRQ)
9.8%

iShares S&P/TSX SmallCap (XCS)
-2.6%

Vanguard Total Stock Market (VTI)
13.4%

Vanguard Small Cap Value (VBR)
15.7%

iShares MSCI EAFE Value (EFV)
14.5%

iShares MSCI EAFE Small Cap (SCZ)
16.8%

Vanguard Emerging Markets (VWO)
15.8%

SPDR Dow Jones Global Real Estate (RWO)
21.9%

BMO Mid Federal Bond (ZFM)
2.8%

BMO Short Corporate Bond (ZCS)
3.6%

9.0%

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ETF Webinar Today

This afternoon (Tuesday, August 14) I will be participating in a webinar called “ETFs in Portfolio Management and Construction,” moderated by Yves Rebetez of ETF Insight. I’ll be joined by two industry professionals who are much smarter and better dressed than I am: Alfred Lee, Vice President and Investment Strategist for BMO ETFs, and Tyler Mordy, Director of Research, HAHN Investment Stewards.

We’ll be discussing the various ways that ETFs can be used to build diversified portfolios. I’m going to cover the basics using the Complete Couch Potato as an example. This  portfolio provides extremely broad diversification with just six ETFs, all for an annual fee of 0.29%. The other panelists will consider some more advanced strategies, including adding alternative asset classes to traditional stock-bond portfolios.

I welcome you to join us at 4:15 pm EST. For login information and links, visit ETF Insight.

Book giveaway winners

Thanks to everyone who entered the draw for one of three copies of my new book, The MoneySense Guide to the Perfect Portfolio. There were more than 250 entries,

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What’s Next for iShares — Part 2

Here is part two of my interview with Mary Anne Wiley, Head of iShares, who explains what to expect in the wake of BlackRock’s acquisition of Claymore. You can read the first part of the interview here.

Claymore pioneered some innovative programs, such as preauthorized cash contributions (PACCs) and dividend reinvestment plans (DRIPs), as well as the Scotia iTrade partnership that brought commission-free ETFs to Canada. Will those programs continue?

MAW: Let me take each one of those individually. Claymore did have a program with PACCs, DRIPs and SWPs, and by far the DRIPs were the most popular. There are other ways to do DRIPs with the brokerages directly, but not every brokerage has every ETF set up for it, and we want it to be as easy as possible for all types of investors. So we are going to keep all of the programs on the existing funds, and we are looking to expand the DRIPs, in particular, to a wider set of iShares.

As for the commission-free partnerships, we think these are fabulous programs. Anything that encourages investors to try ETFs and get to know them,

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Why You Should Beware of First Dates

Imagine that you’re the marketing director for MegaAlpha Investments and you want to advertise two of your mutual funds. In the September 2011 issue of Performance Chaser magazine, you place the following ad:

Are stocks still worth the risk? Not anymore. Over the last three years, the S&P/TSX Composite Index delivered an annualized return of just 0.2%. Meanwhile, the MegaAlpha Awesome Income Fund earned 6.4% a year. Rather than relying on a disappearing equity premium, our managers delivered reliable yield and significant growth with a portfolio of the highest quality government and corporate bonds.

Three months later, in the December issue, you run a different ad:

Are stocks still worth the risk? You bet. Over the last three years, the MegaAlpha Awesome Equity Fund  delivered an annualized return of 12.5%, dramatically outperforming the DEX Universe Bond Index, which returned just 7.7%. Rather than relying on the perceived safety of bonds, our managers took advantage of generous dividends and capital growth in a portfolio of leading Canadian companies.

Do you think I made those numbers up? Nope. Both the index returns and the funds’ performance are real—except the “MegaAlpha Awesome Income Fund” is actually the iShares DEX Universe Bond Index Fund (XBB),

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