Welcome back to the Canadian Portfolio Manager podcast, where we’ll continue on with our Spaceballs-inspired exploration of the new CPM model portfolios. I’m your host, Justin Bender, and in today’s episode, we’ll introduce our moderately complicated Ridiculous portfolios.
Our models now range from our simple (but not simplistic!) Light portfolios, to our bordering-on-insanely complicated Plaid portfolios.
To be honest, most of you can probably begin and end your adventures with a Light portfolio; you’ll still be light years ahead of most DIY investors. But I know some of you may prefer to boldly go where no DIYers have gone before. That’s fine, as long as you’re up for the challenge, and you know all the facts.
Most importantly, managing a more complex portfolio is, unsurprisingly, more troublesome. Is it worth it? Usually not. But for the uncommonly intrepid, there may be rewards worth reaping.
After you’ve considered today’s Ridiculous model portfolios, it’s your call: Will you continue onward, or hit the emergency stop button and head toward the Light? You decide; but first, let’s check out these ridiculously good-looking models.
The Ridiculous portfolio reports are also available for download in the Model ETF Portfolios section of the Canadian Portfolio Manager blog, to the right of the Light portfolios. You can click on either the Vanguard or iShares ETF buttons in Step 2, which will generate the report in a separate tab. Once again, you may now want to hit pause on this podcast, and download one of the Ridiculous model ETF portfolio reports, so you can follow along with me.
Similar to their Light portfolio counterparts, the Vanguard or iShares Ridiculous portfolios are displayed from left to right, ranging from a very conservative 80% bond, 20% stock portfolio, all the way to a very aggressive 100% stock portfolio. Below the blue and grey donuts, you’ll find the percentage weights allocated to each ETF. To allow for cost comparisons and other portfolio management conveniences, I’ve used the same Canadian, U.S., international, and emerging markets equity ETF weightings in both the Ridiculous and Light portfolios.
The report is further divided horizontally into three account-type sections:
- TFSA, RESP, and RDSP Accounts
- RRSP, RRIF, LIRA, and LIF Accounts
- Taxable Accounts
In each section, we’ve adjusted the specific holdings to reduce product costs and increase tax efficiency within the overall portfolio. For each asset mix, you’ll also find the weighted-average management expense ratio, or MER, as well as the foreign withholding tax ratio, or FWTR.
You can directly compare these figures to those found in the Light portfolio reports. For example, in an RRSP, the Vanguard 40% bond/60% stock Ridiculous portfolio would have a combined MER and FWTR of 0.14%. In comparison, the Vanguard Balanced ETF Portfolio (VBAL) from the Light portfolio report would cost 0.42% in an RRSP, for a total cost difference of 0.28% per year.
Although the report looks intimidating, there are only a handful of differences between the Ridiculous and the Light portfolios. I’ll take you through them now.
Fixed Income Differences: Light vs. Ridiculous
First, there’s some foreign bond differences. Specifically, I’ve dropped the foreign bond ETFs from the Vanguard Ridiculous portfolios, due to their higher product costs and foreign withholding taxes. I’ve instead opted for the Vanguard Canadian Aggregate Bond Index ETF (VAB) in all account types except taxable accounts. This change also reduces the number of holdings in an already-complex portfolio.
As iShares doesn’t yet provide CAD-hedged versions of their U.S.-based bond funds, it was an easy decision to stick with the iShares Core Canadian Universe Bond Index ETF (XBB) in most account types.
I’ve also excluded the iShares Core Canadian Short Term Corporate + Maple Bond Index ETF (XSH) from the iShares Ridiculous portfolios. This decision (along with excluding U.S. bonds) increases the duration risk from 7 years for the iShares Light portfolios to 8 years for the iShares Ridiculous portfolios.
In taxable accounts, I’ve swapped out VAB and XBB in favour of the BMO Discount Bond Index ETF (ZDB). Because it invests in lower-coupon bonds, with less taxable annual interest, ZDB is expected to be slightly more tax-efficient than the other two.
Equity Differences: Light vs. Ridiculous
Next, let’s take a look at the equity differences in our Light vs. Ridiculous portfolios, starting with U.S.-listed foreign equity ETFs.
In tax-deferred accounts (like RRSPs, RRIFs, LIRAs, and LIFs), I’ve replaced the Vanguard U.S. Total Market Index ETF (VUN) with the U.S.-based Vanguard Total Stock Market ETF (VTI). I’ve also replaced the Vanguard FTSE Emerging Markets All Cap Index ETF (VEE) with the U.S.-based Vanguard FTSE Emerging Markets ETF (VWO). These changes reduce product costs and foreign withholding taxes in tax-deferred accounts.
I decided to leave the Vanguard FTSE Developed All Cap ex North America Index ETF (VIU) alone for now. It’s nearly as tax-efficient as other comparable U.S.-based ETFs. And there is no perfect U.S.-based substitute for it. If you’d rather squeeze every last basis point out of your international equity ETFs, I’ve provided some ideas in my blog post, More Alternatives to Vanguard’s Asset Allocation ETFs.
The iShares Light portfolios already hold the U.S.-based iShares Core S&P Total U.S. Stock Market ETF (ITOT) and iShares Core MSCI Emerging Markets ETF (IEMG). But, as asset allocation ETFs with a fund-of-funds wrap structure, these funds don’t benefit from the usual tax advantages. Instead, a Canadian investor can hold ITOT or IEMG directly in their RRSP, and eliminate the 15% U.S. withholding tax on foreign dividends. To reap this tax benefit, I’ve placed these U.S.-based ETFs in the iShares Ridiculous portfolios as direct buys. To further reduce product costs I’ve also swapped out the Canadian-based iShares Core MSCI EAFE IMI Index ETF (XEF) for the U.S.-based iShares Core MSCI EAFE ETF (IEFA). If you’d rather stick with XEF, that’s fine too.
In TFSAs and taxable accounts, I’ve included only Canadian-based iShares foreign equity ETFs. In terms of foreign withholding tax, there is no advantage to using U.S.-based ETFs in these account types, so why bother? In fact, doing so can sometimes lead to even higher withholding taxes.
Using VEQT and XEQT in TFSA and Taxable Accounts
If you’re also overwhelmed with the thought of placing so many trades, we may be able to tone it down for you. Instead of holding four equity ETFs in your TFSA or taxable accounts, you could swap your Vanguard portfolio’s VCN/VUN/VIU/VEE holdings for the Vanguard All-Equity ETF Portfolio (VEQT). Or for the iShares portfolio, you could swap your XIC/XUU/XEF/XEC holdings for the iShares Core Equity ETF Portfolio (XEQT). The Ridiculous portfolios’ equity region weights are identical to the 100% Vanguard and iShares asset allocation ETFs, so you can think of them as interchangeable. Your product costs will increase slightly, but you’ll still maintain most of your cost savings, with slightly less ridiculous portfolio management.
Now before we discuss reasons for and against investing in the Ridiculous portfolios, let’s tune in to another ETF Kombat!
In today’s show-down, three funds will join forces to battle a common ETF enemy.
The BMO Discount Bond Index ETF (ZDB) will take on three of its rivals: the Vanguard Canadian Aggregate Bond Index ETF (VAB), the iShares Core Canadian Universe Bond Index ETF (XBB), and the BMO Aggregate Bond Index ETF (ZAG). This time, rather than do battle in the traditional tax-deferred or tax-free account, our contestants will duke it out in the taxable arena.
Although all four bond ETFs provide low-cost and diversified Canadian bond exposure, there can be only one winner in this ETF Kombat.
When it comes to buying bonds in taxable accounts, a good rule of thumb is to only buy a bond with a similar or lower coupon than its yield to maturity. Premium bonds, or those with coupons significantly higher than their yield to maturity, should be avoided in taxable accounts. All else equal, this is expected to provide investors with higher after-tax returns.
Unfortunately, the indexes followed by traditional bond ETFs, like VAB, XBB and ZAG, have average coupons that are significantly higher than their average yield to maturity, indicating a portfolio chock-full of tax in-efficient premium bonds.
ZDB, on the other hand, invests in bonds with a coupon rate equal to or less than 1.2 times the yield to maturity of the security. It also maintains similar risk to the broad Canadian investment-grade fixed income market.
At the end of 2019, ZDB, VAB, XBB and ZAG all had similar 5-year average returns, at least before-taxes. But on an after-tax basis, ZDB outperformed the others by around 0.2% per year, assuming the investor was an Ontario top rate taxpayer. Although this figure may seem small, remember that this is ZDB’s after-tax outperformance. The other three funds would have needed to outperform ZDB by around 0.4% per year before-tax to compete with ZDB’s tax-efficient structure. Most investors wouldn’t pay an additional 0.4% for a traditional bond ETF, but that’s what they effectively did when they held VAB, XBB or ZAG in their taxable accounts over the past five years.
“Z-D-B wins.” – Flawless Victory.
The FTSE Canada Universe Bond Index is the go-to benchmark for most bond funds. XBB follows this exact index, while ZAG follows a close version of it. VAB and ZDB follow slightly different indices, so when their investors benchmark either fund’s performance to the universe bond index, they are expected to see larger tracking differences. For example, in 2017, ZDB was the top laggard out of the group, underperforming the universe bond index by 0.8% that year.
Although these yearly tracking differences tend to even out over the long-run, it may cause some short-term confusion when investors experience a noticeable year of underperformance, relative to this popular benchmark.
Because of its “sub-zero” tracking error, ZDB won’t stand a chance against an ETF like XBB, whose returns are expected to closely track the universe bond index.
VAB, XBB and ZAG each hold around 1,000 to 1,300 individual bonds, while ZDB holds only around 200. Usually this would indicate a high level of diversification for our bond trio, and an undiversified bond portfolio for ZDB. However, looks can be deceiving, especially with bond funds.
For example, about 35% of each bond fund is made up of high-quality Canadian federal government bonds, which have the lowest amount of default risk. ZDB holds around 20 federal bonds, while an ETF like XBB currently holds around 90. Even though XBB has a higher number of actual bonds, this doesn’t reduce the credit risk of the portfolio, as they all have the same issuer: the Canadian government.
The same goes for provincial bonds. These make up another 35% of each fund. The largest issuer is the Ontario government, whose bonds account for around 15% of each ETF. ZDB only holds 5 Ontario bonds, while XBB holds 35. However, in terms of credit risk, there isn’t much difference between the two.
So to recap, 70% of each fund is invested in either federal or provincial bonds, which have a low risk of default, so they do not require a higher number of actual bonds to be properly diversified).
The remaining 30% of each fund is invested in corporate and municipal bonds. Once again, the number of actual corporate or municipal bonds does not give an accurate read on the specific issuer exposure.
For example, XBB holds 75 bonds issued by the big five Canadian banks, which account for another 7% of the fund. ZDB, on the other hand, holds only 24 bonds issued by the same big five banks, but their overall weight only accounts for around 4% of the fund. This indicates that ZDB may actually have better corporate issuer diversification than the other funds, even though it holds far fewer actual bonds).
So, if anyone tells you that ZDB is less diversified because it has fewer bond holdings, you can let them know that’s just not true.
The big differentiator between ZDB and the other bond ETFs is ZDB’s improved tax-efficiency in taxable accounts. The after-tax performance numbers just don’t lie. After five years, ZDB has proven itself to be the most worthy bond contender for your taxable investment dollars.
“Z-D-B wins – After-Tax Frugality
Advantages of the Ridiculous Portfolios
Alright, that was a nice break, but let’s get back to our portfolio review. Now that you’re familiar with the Ridiculous portfolios, let’s discuss some of their potential benefits.
First, there’s the potential for lower product costs. By ditching some of the higher-cost foreign bond ETFs, adding a dose of lower-cost U.S.-based foreign equity ETFs, and performing your own portfolio rebalancing, you can further reduce your already rock-bottom product costs.
You can also lower your foreign withholding taxes. By opting for U.S.-listed foreign equity ETFs in your RRSP, you can reduce the unrecoverable withholding taxes on your foreign dividends.
Holding lower-coupon bond ETFs like ZDB in your taxable accounts can also increase your after-tax return – at least relative to holding traditional bond ETFs, like VAB or XBB. It’s coupon clipping at its finest.
What if you don’t like the equity weights or specific ETF holdings in the Ridiculous portfolios? No problem. You can mix and match them to your own liking.
Last up, there are more tax-loss selling opportunities in your taxable account. If you’re investing in multiple ETFs, one or more of them may be in the red more often than a one-fund balanced ETF portfolio. A disciplined tax-loss selling strategy could come in handy, especially if you’ve just realized big gains by switching to a new portfolio.
Disadvantages of the Ridiculous Portfolios
Of course, by seeking to improve on the Light portfolios, we’re bound to add some relative downsides as well.
First, you need a big account. If your RRSP is worth $10,000, you’re only saving about $28 per year on your Ridiculous portfolio, relative to a Light portfolio. And that’s before factoring in your additional trading commissions and currency conversion costs. Make sure your portfolio value is well into 6 digits or higher before considering a switch.
You’ll also be placing more trades. More ETF holdings to manage across each account creates more trading costs and complexities. If you’re regularly contributing to your portfolio, the commissions can start to offset some or even all of your cost savings.
Don’t forget you’ll need to rebalance your own portfolio. In place of an elegant one-fund solution, your accounts now resemble a crudely constructed Frankenstein’s monster. Good luck manually keeping this beast in balance over time.
With more ETFs at play, you’ll also need to track more adjusted cost bases, or ACBs in your taxable account. Tracking the book value for a single ETF is a whole lot easier.
Last up, you’ll need U.S. dollars in your RRSP, which means you’ll need to master Norbert’s gambit to cheaply convert your Canadian dollars to U.S. dollars for this purpose. This strategy has a cost, so you’ll again need to ensure you’re only converting larger amounts. I’d say at least $10,000 a pop.
Could this all be a ridiculous waste of time, or are you ready to replace your nearly perfect asset allocation ETF for a slightly cheaper Ridiculous portfolio? Before you do, know that I’m not a big fan of them in their current form. I don’t even typically manage my client portfolios like this. That’s right, just like Dark Helmet in Spaceballs, I too prefer to skip over Ridiculous and head straight to Ludicrous with my portfolio complexity. (gasp)
So why bother with the Ridiculous portfolios in the first place? Great question. As we continue on our quest for portfolio perfection, we’ll be using the same ETFs from the Ridiculous portfolios, but adjusting their weights in each account type to maximize overall tax efficiency. You might think of them as a stepping stone toward creating even more complex model portfolios.
Before you go, let’s check to see if we have any new voicemail messages from our listeners.
First off just wanted to thank you for all the content on the blog. It’s really helped me out on my journey to investing. I moved to Canada about 2 years ago and I found it very valuable. I wanted to ask you about changes in the recommended ETF allocations. So, a couple months ago, I was following the recommendations from your June chart on the model ETF asset allocation. And today, as I was just rebalancing my brokerage account, I noticed that there was an update, And I also noticed that some of the funds had changed, as well as the asset allocation for some of them.
So, I was just wondering, do you recommend somebody who is following your ETF allocations to keep them up to date? I’m assuming you maybe do more evaluation every year and come up with a new model or new recommended allocation for ETFs. Or, let’s say I started with the one your recommended in June of 2019, should I stick to that So I just wanted to know your thoughts on that – thanks.
Thank you for such a detailed question. I’m really so glad to hear the CPM blog helped you with your investing journey, and at a time when you no doubt had a lot on your plate with your recent move to Canada.
I do apologize for my year-end model portfolio surprise update. It’s never my intention to confuse my readers, but occasionally the portfolios do need a few tweaks here and there. When improvements are truly warranted, I figure ignorance is NOT bliss.
So, as you mentioned, some of the funds have changed, as well as their specific weights within the portfolios. Rest assured, the overall investment philosophy hasn’t changed. In fact, the Vanguard Ridiculous portfolios provide almost identical market exposure as my old CPM portfolios, even though they include a handful of new ETFs with slightly different asset allocations.
For example, the old CPM portfolios were comprised of a Canadian bond ETF (ZAG), a Canadian equity ETF (VCN), and a foreign equity ETF (XAW). For investors who wanted to reduce product costs or foreign withholding taxes in their RRSP, XAW was broken down further into its underlying U.S., international and emerging markets ETFs. That is, into XUU, XEF and XEC, or their U.S.-based counterparts, ITOT, IEFA, IEMG.
Within XAW, the foreign equity ETFs are weighted relative to their current market caps. If this sounds familiar, it’s because the Vanguard Ridiculous portfolios also weight their foreign equities based on their current market caps. The Vanguard Ridiculous portfolios also include the same Canadian equity ETF (VCN) and a nearly identical Canadian bond ETF (VAB).
The CPM portfolios did include a slightly higher weighting to Canadian stocks than the Vanguard Ridiculous portfolios, at around 33% vs. 30%. However, this one small difference isn’t expected to impact returns over the long term.
If we compare the underlying asset class weights of a typical balanced 60% stock, 40% bond portfolio for the old CPM vs. the new Vanguard Ridiculous portfolios, we find there is minimal difference between their market exposures.
Using each of the funds’ underlying index performance, I’ve also determined that both portfolios would have experienced an identical 7% annualized return over the past 5 years ending December 31, 2019. That’s before fees.
In other words, your current portfolio is not all that different from the new Vanguard Ridiculous portfolios. If there are no tax implications and you like the idea of simplified, essentially single-fund portfolio management, you could consider a switch to the new Light portfolios. But it’s really not necessary.
If your current portfolio includes XAW, think of it as interchangeable with the VUN, VIU and VEE combo in the Vanguard Ridiculous portfolios. And if you hold ZAG instead of VAB, don’t even bother switching it, as both funds have similar fees and Canadian bond exposure.
Next up, we’ll take you on a tour through our Ludicrous portfolios, which may arguably be more worth your while. Talk with you then!