Thanks for tuning in to Episode 6 of the Canadian Portfolio Manager podcast! I hope you and your loved ones are safe and healthy, and managing to find enough things to keep you all busy.
In case you’ve been feeling a little cooped up lately, what better time to press our Spaceballs-inspired accelerator past Light and Ridiculous, and into a Ludicrous level of model portfolio complexity?
Our Ludicrous portfolios include the same ETFs with the same allocations as our Ridiculous portfolios. But they also build in traditional asset location strategies, aimed at increasing your expected after-tax return. In other words, they make sure each ETF is located in its proper account. By locating relatively tax-inefficient assets (like bonds) in tax-deferred accounts and tax-efficient assets (like equities) in tax-free and taxable accounts, the goal is to achieve warp-speed tax-efficiency across your entire portfolio.
Most modern asset locators will roll their eyes at this traditional asset location advice. I myself have posted blogs sympathizing with their stance. However, without the ability to predict future tax rates, fund distributions, etc., I’ve suggested that most DIY investors may be better off simply holding the same asset mix in each account type.”
Then again, I’ve also pointed out that many of my CPM listeners aren’t your average DIY investors! “Good enough” just won’t do, when even better, optimal strategies exist. And there are still many benefits to managing your portfolio according to these traditional asset location rules … even if they can become a little ludicrous.
In this episode, I’ll take you through the steps involved in setting up your very own Ludicrous portfolio. We’ll also compare the actual 2019 after-tax performance differences between Light, Ridiculous and Ludicrous balanced portfolios (as well as the reasons for any after-tax outperformance). I’ll then provide a list of pros and cons of the Ludicrous portfolios, to help you decide whether this asset location strategy is for you.
As always, this podcast is also available in blog format, so feel free to have it up as we work through the examples. I’ve also included 10 Vanguard and iShares Ludicrous portfolio examples in the model ETF portfolio section of the CPM blog, which should provide you with more ideas as you design your portfolio.
Since our Ludicrous portfolios’ make-up is identical to their Ridiculous portfolio counterparts, it’s not technically a separate model. It’s really more a different process for managing your holdings across your accounts. The basic process goes something like this:
First, plan out your asset allocations, and determine the dollar amounts to purchase in each asset class. For example, if you have a $1 million portfolio with an 18% target Canadian equity allocation, you would want to purchase $180,000 of Canadian equities.
Second, fill your TFSA with as many of your equity ETFs as you can … with two variations on that theme. I prefer to hold a mix of Canadian, U.S. international, and emerging markets ETFs in the TFSA. But some investors prefer to prioritize holding their Canadian equity ETFs in their TFSA, to reduce the portfolio’s overall unrecoverable foreign withholding taxes. I personally don’t have an issue with this approach either, and have implemented both with my clients.
Third, try to locate the rest of your equities in a taxable account if you can. Base your selections on which are expected to result in the lowest annual taxes payable. So you would purchase relatively tax-efficient U.S. or Canadian equity ETFs first (with the order depending on your taxable income and where you live in Canada). Then you’d opt for emerging markets equity ETFs. Relatively tax-inefficient international equity ETFs come last.
Fourth, make your RRSP your last stop for locating any left-over equities. This is only if you still need to purchase more equities after your TFSA and taxable accounts have been filled up. In your RRSP, you’d locate these equity ETFs in the opposite order of how you did it in your taxable account. So, you’d purchase international equities first, then emerging markets equities, and then either Canadian or U.S. equities. If you’re comfortable with Norbert’s gambit, you could purchase U.S.-based foreign equity ETFs in your RRSP to reduce your overall product costs and foreign withholding taxes.
Fifth and finally, round out your taxable account (and RRSP) with bonds. If your equities have now all been purchased and you still have dollars left to invest in your taxable account, you could purchase a tax-efficient bond ETF with your remaining cash, like the BMO Discount Bond Index ETF (ZDB). You could then purchase a traditional (less tax-efficient) bond ETF in your RRSP to round off your fixed income allocation.
Now for the million-dollar question: Does this old-school asset location strategy actually work?
As we now have a full year of actual (not back-tested) performance and tax data for our Light balanced portfolios, we can compare their 2019 after-tax returns to those of our Ridiculous and Ludicrous balanced portfolios.
For our example, we’ll assume an Ontario top-rate taxpayer and multimillionaire “Pat” invests $1 million in each of our Vanguard Light, Ridiculous and Ludicrous 40% bond / 60% stock model portfolios at year-end 2018. Being the adventurous type, Pat invests $100,000 in each TFSA, $500,000 in each RRSP, and $400,000 in each taxable account. Pat continues to hold these investments until year-end 2019, and then sells everything and deregisters the RRSP assets. (Obviously, Pat’s behavior is more than a little ludicrous, but for the sake of our experiment, we’ll cut our friend some slack.)
2019 is a decent period to analyze, as all asset classes had positive performance, but stocks still handily beat bonds. This is what most investors would expect from these asset classes over the long-term, so it makes for a good microcosm, if you will.
In my blog version of today’s discussion, I’ve included examples showing how Pat located each ETF in each account type at the beginning of the experiment. Keep in mind, since Vanguard’s foreign equity allocations are market-cap weighted, the percentage values in our examples will be slightly different than those seen in our current model portfolios.
So, viewing the blog data charts, you’ll see that the TFSA is now 100% equities, with 30% in a Canadian equity ETF (VCN), and 70% in three market-cap weighted foreign equity ETFs (VUN, VIU and VEE).
Also, here’s a quick tip: As the Vanguard All-Equity ETF Portfolio (VEQT) is now available to investors, you could consider simplifying your TFSA investment by replacing VCN/VUN/VIU and VEE with VEQT. Or, if you’re following the iShares Ludicrous portfolios, you could replace XIC/XUU/XEF and XEC with XEQT, which is the iShares Core Equity ETF Portfolio.
Either way, back in the taxable account, there is almost enough room for the remaining equities, except for the most tax-inefficient international equity ETF, VIU, which has the highest taxable distribution. Only $18,010 of VIU will fit into the taxable account, so we’ve put the remaining $100,000 allocation into the RRSP account.
Finally, VAB rounds out the entire bond allocation with the remaining RRSP balance.
So … how did Pat do? At the end of 2019, after all securities have been sold and RRSPs deregistered, we find that the Ridiculous portfolio had a slightly higher after-tax portfolio value and after-tax return than the Light portfolio. The numbers were $824,152 vs. $822,456, and 12.54% vs. 12.3%, respectively.
This makes sense. We already knew that the Ridiculous portfolios are cheaper and more tax-efficient than the Light portfolios. Unsurprisingly, the Ridiculous portfolio offered lower product costs and foreign withholding taxes from its U.S.-based ETF holdings, and higher tax-efficiency by holding ZDB in the taxable account.
The more interesting result is the relatively high after-tax performance found in the Ludicrous portfolio. It has a much larger after-tax portfolio value and after-tax return of $833,932 and 13.87%, respectively. Again, this compares to $822,456, or 12.3%, for the Light portfolio, and $824,152, or 12.54% for the Ridiculous portfolio.
So, what’s causing the Ludicrous portfolio’s huge performance advantage?
If you think I’m going to say it’s all thanks to our painfully meticulous asset location activities, you can think again. The Ludicrous edge actually all comes down to differences between each portfolio’s after-tax asset allocations. In all portfolios, the RRSP is worth $500,000 before the government gets its cut. But once we factor in future taxes at the top Ontario tax rate, the RRSP is really only worth $232,350 [which is calculated as $500,000 × (1 – top Ontario tax rate of 53.53%)]. As the Light and Ridiculous portfolios hold the same asset mix across all accounts (including the RRSP), their initial after-tax asset allocation is still 40% bonds and 60% stocks. Sure, each security held in the RRSP is worth less from an after-tax perspective, but the overall portfolio’s asset mix stays the same, before- and after-tax.
On the other hand, the Ludicrous portfolio has a significantly more aggressive after-tax asset allocation of around 25% bonds and 75% stocks. This is because the portfolio holds its entire $400,000 bond allocation in the RRSP. From an after-tax perspective, this $400,000 bond allocation is only worth $185,880 [which is calculated as $400,000 × (1 – the top Ontario tax rate of 53.53%)]. If we divide this after-tax fixed income value by the after-tax value of the entire portfolio, we end up with only a 25.38% after-tax bond allocation.
In other words, to determine whether the Ludicrous portfolios are actually more tax-efficient than the Light or Ridiculous portfolios, we have to make sure we’re comparing portfolios with the same after-tax asset allocations. If we adjust the before-tax asset allocation of the Ludicrous portfolio in our prior example so its after-tax asset allocation matches the Light and Ridiculous portfolios (i.e. 40% bonds, 60% stocks), we would need to start with approximately 56% in bonds and 44% in stocks.
If we run the same after-tax return analysis using this new portfolio, we find that the adjusted Ludicrous portfolio actually ends up with a lower after-tax portfolio value and return than any of our other portfolios – $819,840 and 11.95%, respectively. This would indicate that it’s not the tax-efficiency of the original Ludicrous portfolio that made it superior. It was because Pat was perhaps unwittingly taking on more after-tax equity investment risk.
As I’ll cover later in the podcast in more detail, if you can live with this technically tax-inefficient portfolio to increase your expected after-tax portfolio value, Ludicrous investing can still be a great strategy. But it’s best if you go in knowing the facts.
Now before we discuss reasons for and against investing in the Ludicrous portfolios, I’ve been receiving many reader questions asking for my top pick for the best U.S. equity ETF to invest in. This sounds like a perfect opportunity for another ETF Kombat!, where we pit two ETFs against one another to test their might.
In today’s show-down, two very similar U.S. equity ETFs will go head-to-head for your investment dollars. PWL’s Director of Marketing, Martin Dallaire, will once again be judging the match. In one corner, we have the iShares Core S&P U.S. Total Market Index ETF (with ticker symbol XUU). In the opposite corner, spoiling for a fight, there’s the Vanguard U.S. Total Market Index ETF (with ticker symbol VUN). Although either ETF will provide investors with low-cost and diversified U.S. equity market exposure, there can be only one winner in this “ETF Kombat”.
“Round One…Fight!”:
Both funds now have five years of actual performance data, as of March 31st, 2020. After deducting all fees and foreign withholding taxes, XUU’s average return during this period was 7.89%, while VUN returned 7.57%, lagging its rival by 0.32% per year. This relatively large outperformance deserves more scrutiny, considering XUU and VUN’s underlying index performance only differed by around 3 basis points. We’ll put XUU’s performance under the microscope in round two, but it cannot be denied that XUU’s performance bested VUN’s … at least over the past 5 years.
“X-U-U wins.” (“But past performance is no guarantee of future results”).
“Round Two…Fight!”:
VUN follows the CRSP US Total Market Index, which tracks the performance of over 3,000 large, mid, small and micro-cap companies. XUU follows the S&P Total Market Index, which also tracks the performance of over 3,000 large, mid, small and micro-cap companies. These indexes are nearly identical, and also had nearly identical returns over the past five years – so what caused the performance differences between XUU and VUN? To answer that, we’ll have to dig a bit deeper into their underlying holdings.
To take advantage of economies of scale from our U.S. neighbours, VUN simply holds a U.S.-based fund, the Vanguard Total Stock Market ETF (with ticker symbol VTI). This makes great sense, as VTI follows the same index as VUN. This U.S.-wrap structure also has comparable foreign withholding tax implications, relative to VUN purchasing thousands of U.S. stocks directly (which wouldn’t be very practical anyway).
XUU also has a perfect U.S.-based counterpart, the iShares Core S&P Total U.S. Stock Market ETF (with ticker symbol ITOT). ITOT tracks the exact same index as XUU, so you’d assume XUU would simply allocate 100% of its portfolio to ITOT shares. That would make sense, but iShares has instead chosen to hold not one, but four U.S.-based U.S. equity ETFs. Although XUU does allocate a portion of its holdings to ITOT, it also holds a large-cap S&P 500 ETF, a mid-cap ETF and a small-cap ETF.
These portfolio differences have given XUU a large-cap bias, relative to VUN. As U.S. large cap stocks outperformed their smaller cap counterparts by an average of 7% over the past five years, this explains why XUU was able to handily outperform VUN.
Now before you get too excited, know that this could have gone the other way as well. If small-cap stocks outperform larger companies over the next 5 years, VUN may have the upper hand over XUU. Either way, if you’re a true index investor, the active shenanigans going on in XUU should make you question whether the fund is truly being managed passively.
“V-U-N wins.” “Are we having – vun yet?”
“Round Three…Fight!”:
No ETF comparison would be complete without discussing fees. In January 2016, iShares slashed XUU’s MER to 0.07%, while Vanguard has yet to follow suit with a fee cut for VUN. With an MER of 0.16%, VUN still remains more than twice as expensive as XUU.
Vanguard’s resistance to drop their fees on VUN has me considering starting my own ETF company. I’ll launch a low-cost U.S. equity ETF that charges 0.07% and simply holds VTI. I should be able to shift some of the $2 billion plus in assets VUN has managed to accumulate into my newer, cheaper fund. And, hey, it even looks like the ticker symbol BNDR is still up for grabs!
“Hilarious”
“Finish it”
All jokes aside, I have no plans to start a competing ETF company. But I would like to emphasize that VUN would be my preferred choice for a Canadian-based U.S. equity ETF, if it weren’t for its higher fee. Until Vanguard slashes its MER in half, my hands are tied – I’m forced to award the match to XUU, even with its slightly active ETF selection process.
“X-U-U wins – Frugality”
Okay, now back to our ludicrously long discussion. So maybe we haven’t found the holy grail of tax-efficient investing with our Ludicrous portfolios. But there are still quite a few great reasons to consider using them for your own investments.
First, the Ludicrous portfolios do still offer higher expected after-tax returns. Even though the portfolio’s tax-efficiency may be a bit of a mirage, the higher expected aftert-tax portfolio value is very real. Your product fees and unrecoverable withholding taxes will also be lower than with the Light portfolios.
Second, the Ludicrous portfolios may help you more calmly tolerate a higher investment risk, in pursuit of higher expected rewards. As far as our fictitious investor Pat was concerned, the portfolio was a 60/40 stock/bond portfolio. All of Pat’s statements and performance reports would indicate the same, as they are all reported on a before-tax basis. The Ludicrous portfolios can be a great way to trick your brain into thinking you’re taking the same amount of risk as the other portfolios, while increasing your expected after-tax return. There are so few opportunities in investing where irrational behaviour can work to your benefit, why not take advantage of this one?
Third, at no point will you need to predict future tax rates to successfully manage your Ludicrous portfolio. As you’ll discover in our next podcast, when we cover our Plaid portfolios, it helps to be psychic if you want to truly optimize for asset location. And that’s a tall hurdle to overcome.
Fourth, the Ludicrous portfolios invest more of your lower-yielding bonds in the RRSP, so this account isn’t expected to grow as quickly as your TFSA or taxable account. This can reduce the amount of mandatory minimum RRIF withdrawals at age 72, which could also lead to fewer Old Age Security (OAS) clawbacks in retirement.
Fifth, and perhaps one of my favorite reasons, Norbert’s gambit may not be required. Depending on your asset mix and account values, you may not need to hold U.S.-based ETFs in your RRSP to reduce the withholding tax drag. If you can hold your entire equity allocation in your TFSA and taxable account, you can get away with just purchasing Canadian-based ETFs.
Sixth, the Ludicrous portfolios tend to have fewer holdings to manage than the Ridiculous portfolios. This is especially true if you decide to simply hold a 100% equity ETF, like VEQT or XEQT, in your TFSA and taxable accounts.
Seventh, you have more opportunities for tax-loss selling, especially if you have a large-enough taxable account for holding most of your equities.
And lastly, there are more opportunities for donating securities in-kind. As most of your equities will be held in your taxable account, you will be able to donate ETFs with large unrealized capital gains to your favourite charities without selling them first. This could enable you to completely avoid capital gains taxes on your security donations.
Now, to the potential disadvantages to managing a Ludicrous portfolio. There are nearly as many to consider.
First, they’re more complicated. Nothing beats the Light portfolios in terms of DIY simplicity. I list this as the primary disadvantage for good reason. Time = money!
Second, you will be taking more after-tax equity risk. Even though it may not feel like it, remember that you’re sharing less of the portfolio risk load with the government, relative to holding the same asset mix across all accounts.
Third, your rebalancing spreadsheet will get a workout. Any time you add new money to the portfolio, or withdraw funds from it, you will need to review all accounts in your spreadsheet, and determine which trades need to be placed. You’ll do so on a consolidated-portfolio rather than an account-by-account basis.
Fourth, relative to the Light portfolios, you’ll need to track more adjusted cost bases on the multiple ETFs held in your taxable accounts.
Fifth, your accounts will perform differently from one another. During bull markets, you might be asking yourself why your bond-heavy RRSP is doing so poorly. During bear markets, you’ll be wondering why your TFSA and taxable accounts are underperforming your RRSP. Calculating your portfolio’s performance on a consolidated basis can help with this issue though. Remember, it’s your portfolio’s total returns that matter, not its individual components.
Finally, you could face higher taxable capital gains. For example, say you need to take a large, lump-sum from your taxable account for a down payment on a new home or a similar spending need. Since your taxable account has a higher allocation to equities – which will hopefully rise in value over the years – you may find yourself needing to realize more capital gains relative to our other portfolios.
In addition, if you can’t keep your portfolio in balance by injecting new cash into it when needed, you may need to instead rebalance periodically by selling equities in your taxable account. This is another way you may need to realize taxable capital gains in the process. In contrast, the Ridiculous portfolios hold substantial equities in the RRSP account, where you can rebalance with no tax consequences.
Hopefully this discussion has given you the ingredients you need to identify the best portfolio “recipe” for your tastes. But before you to get back to your actual bread-making – or whatever you’re busy doing from the comfort of home – let’s check our voicemail messages to see if we have any listener questions.
Hi Justin,
My name is Wendall, from Montreal. My question for you for Ask Bender is, with the onset of the one-stop shopping of asset allocation ETFs, some of us are concerned with the tax implications for simply buying something like VBAL in both our RRSP, TFSA and taxable non-registered account. It seems for those of us who know how to DIY invest and purchase ETFs from a discount brokerage, separating the ETFs into bonds and equities would make sense as we could purchase the equity ETFs in our tax-free and non-registered accounts. I understand that you’ve spoken about the tax implications, but does it really matter for most investors this savings and additional returns you’ll get from being more tax-efficient, or is it a much less of a hag to simply buy VBAL in every account and not think about it?
Hey Wendall,
Thanks for reaching out. I’m sure many listeners are asking themselves the same question: Does all this technical portfolio tax stuff really matter for most investors?
We’ve certainly shown how an investor in Pat’s specific situation could benefit financially from a more complicated portfolio. But Pat is not a great representation of “most investors”. With millions of dollars to invest, Pat is in the top tax bracket, which increases the benefits of her asset location strategies. As a fictional character, she is also able to perfectly implement and manage her more complicated ETF portfolios with zero emotion, and zero trading costs.
For most real-life investors, there are better ways to grow a portfolio than obsessing over taxes. Even a simple tweak to your savings strategy could put you on par with Pat’s level of success. For example, instead of switching from VBAL to the next most complicated Ridiculous portfolio, you could have just saved an extra $5 per day. In a similar situation, you’d come out about the same, with far less hassles. Plus, if you did have millions of dollars in the bank, it’s unlikely you’d ever miss that $5 daily draw. You could gladly – and wisely – accept it as the price paid to be able to avoid any complexities … such as having to perform Norbert’s gambit or calculate portfolio rebalancing allocations every time you added new money to the mix.
Consider all you’ve already achieved by using a simple asset allocation ETF, like VBAL. You’ve already avoided the most common investor mistakes. You have (hopefully) chosen an asset allocation you can stick with over the long term. You have considerably reduced your costs, relative to the average Canadian investor. Your portfolio is also more diversified than the average portfolio, with thousands of individual stocks and bonds. And finally, by choosing to invest in passively managed ETFs in the first place, you already have an extremely tax-efficient portfolio.
In other words, you’re about 90% of the way there, with very little effort exerted. The other 10% would take exponentially greater effort and discipline, and may not even guarantee a better outcome.
I hope most of you are starting to read between the lines (or listen through the airwaves) of our model portfolio discussions. Although the more complicated Ridiculous, Ludicrous and Plaid portfolios make for a fun and interesting way to frame these common asset location debates, they’re not very practical for the average investor to implement. If you find yourself wondering whether you should switch from a Light to a more complicated portfolio, odds are, you shouldn’t.
We’re nearing the end of our model portfolio adventures. But before we leave you to chart a Light, Ridiculous or Ludicrous course, we have one last model to show you. The Plaid!
What if you wanted your portfolio to incorporate the after-tax asset location concepts just discussed? For example, what if you wanted to start out with appropriate before-tax allocations to shoot for a truly tax-efficient, after-tax 60/40 portfolio? Good news – our Plaid model portfolios will take you there. That’s all coming up in episode 7 – talk with you then!