Last week we looked at the iShares Edge MSCI Multifactor Canada Index ETF (XFC), one of a trio of new ETFs based on multifactor indexes from MSCI. Recall that we found a few surprises in our analysis: a large part of the index’s performance could not be explained by the size, value, momentum and quality factors. Now let’s see how the US and international multifactor indexes hold up to the same analysis.
iShares Edge MSCI Multifactor USA Index ETF (XFS)
My first issue with the iShares Edge MSCI Multifactor USA Index ETF (XFS) is that its underlying index doesn’t use a broad-market parent index (like the MSCI USA IMI Index). Instead, its universe is the MSCI USA Index, which excludes small cap companies. A multifactor ETF that tilts towards small companies is going to have a hard time doing so when their parent index contains only large and mid cap companies. iShares argues that mid cap companies have also historically outperformed large cap companies in the US, so we’ll leave it at that.
The management fees on this product are 0.45%, making it 6-7 times more expensive than the broad market iShares Core S&P U.S. Total Market Index ETF (XUU). XUU also tracks an index that includes 3,817 stocks, while XFS tracks an index of only 135 stocks.
The tracking error of the MSCI USA Diversified Multiple-Factor Index has been lower than most of the other single factor indices, so this should also help investors with their behavioural biases.
Monthly Tracking Error to Index: January 1999 to December 2015
Sources: MSCI, Dimensional Returns 2.0
A 5-factor regression analysis of the multiple-factor index reveals an unexplained alpha of 0.47%, though this is nowhere near as troubling as it was in our Canadian example. Although the index did not have a heavy size or momentum tilt, it did include a healthy dose of value (+0.14) and quality (+0.27), as we should expect.
5-Factor Regression Results: January 1999 to December 2015
*Data shaded in light grey have a t-stat greater than 2, which indicates a statistically significant result
Sources: MSCI, AQR Data Library
While the regression analysis showed few surprises, I do find it odd that none of the individual factor indices outperformed the multiple-factor index over the measurement period. As you can see in the table below, the individual factor indexes had annualized returns no higher than 7.41%. Yet somehow the multi-factor index returned 7.88%. This could be due to a rebalancing bonus of some kind, but the amount just seems high. (Imagine a portfolio of ETFs that earned a higher return than every one of its individual holdings.) Also, the largest tilt in the multiple-factor index was to the quality factor, and yet this was the worst performing individual factor index of the group, at 5.42%.
Performance Summary: January 1999 to December 2015
iShares Edge MSCI Multifactor EAFE Index ETF (XFI)
Similar to XFS, the iShares Edge MSCI Multifactor EAFE Index ETF (XFI) sorts its stocks from an index that excludes small cap companies.
The management fees on XFI are also 0.45%, which is roughly double the cost of the broad-market iShares Core MSCI EAFE IMI Index ETF (XEF). XEF also tracks an index of 3,164 stocks, while XFI includes just 209 companies.
The tracking error of the MSCI EAFE Diversified Multiple-Factor Index relative to the broad-market index is the lowest of the three multiple-factor indices, at 1.15%. It is also lower than any of the individual MSCI factor indices listed below. This should lead to fewer cases of regret among investors who have become accustomed to plain-vanilla indexing.
The 5-factor regression showed a significant tilt towards all factors except momentum. Nothing else in the results really jumped out as being out of place:
If you’ve made it this far, you’ve probably already made the decision to stick with your low-cost, plain-vanilla indexing strategy. Factor investing is enticing, but as we’ve seen with these multifactor indexes, it can be difficult to put into practice. If you use a factor-based ETF that claims to capture the premiums from value or momentum stocks, for example, it’s hard to know whether you’re getting what you’ve been promised. Do you really want to be running 5-factor regressions as part of your due diligence process?
These strategies also have more turnover than a passive strategy (MSCI estimates their global multiple-factor portfolio turnover at 40.1%, relative to 3.1% for their global passive index strategy). In taxable accounts, this increased turnover could result in higher capital gains distributions and lower after-tax returns. I still recommend choosing a strategy that you are comfortable with and that is easy to understand.
So you’ve read all about the benefits of index investing. Your portfolio is dirt cheap and broadly diversified. Heck, you’ve even stopped checking your portfolio value on a daily basis. Just when you thought you had it all figured out, ETF providers drop a bombshell by claiming there may be a smarter way to invest.
Traditional index investing is clearly not dumb, but it can sometimes feel that way. There’s a lot of academic research out there that has shown certain risk factors have historically generated higher returns than the market. By tilting towards any of these factors in your portfolio, you have the potential for market beating returns. Even better, by combining a number of these factors into your portfolio, you may enjoy a smoother ride in your pursuit of outperformance.
Based on this idea, iShares has created three multifactor equity ETFs (Canada, US and International), which follow the MSCI Diversified Multi-Factor Indexes. Instead of tilting towards a single factor, these indices combine four well-researched factors: value, momentum, size and quality. Let’s start by taking a closer look at the Canadian version. I’ll look at the US and international multifactor indexes in my next blog.
iShares Edge MSCI Multifactor Canada Index ETF (XFC)
With a management fee of 0.45%, you’ll pay 9 times more to hold the iShares Edge MSCI Multifactor Canada Index ETF (XFC), compared to its plain-vanilla counterpart, the iShares Core S&P/TSX Capped Composite Index ETF (XIC). You’ll also reduce your stock holdings by a third, from 240 companies to 81 companies.
Tracking error to the index is always an issue with any active strategy (and yes, factor investing is arguably an active strategy). One behavioural issue I’ve found with factor investing is the tendency to constantly compare your returns to the index. If your investment strategy strays too far below the index returns, you may be tempted to abandon it. By combining factors together into a single fund, it may help reduce the tracking error of the fund relative to the index (and help investors avoid making any knee-jerk reactions).
If we calculate the monthly tracking error of the single and multiple-factor MSCI indices relative to the MSCI Canada IMI Index (“the market”), we find that the MSCI Canada IMI Select Diversified Multiple-Factor Index tracking error is similar or lower than nearly all of the individual factor indices (with the exception of the quality index).
No factor discussion would be complete without a regression analysis. I know that most of my blog readers hate these things. But the fact is, this statistical technique is the best way to measure whether a factor-based index is behaving the way you would expect.
In the tables below, I’ve compared the regression results for a broad-market index with those of the multiple-factor index. For each factor (size, value, momentum, quality) the amounts for the multiple-factor index should be higher than the broad-market index—this indicates the factor tilt. In this analysis, “alpha” represents the portion of the returns explained by something other than that factor tilt. So if the multi-factor strategy performs as expected, you should expect an alpha of zero.
Although the Canadian multiple-factor index had significant tilts towards momentum (+0.07), quality (+0.07) and size (+0.21), it had a negative tilt toward value (-0.03). That’s hard to explain. Also, since size was its biggest factor tilt, I would have expected to see outperformance of smaller companies over the measurement period. But if we review the index performance in the chart above, we find that smaller companies returned about 7.06%, while the market returned 7.24% (whoops).
Things get even more confusing. The unexplained alpha over the period was a whopping 2.41% per year. These results make me question whether there is something else driving the back-tested multiple-factor outperformance – if this is the case, investors may not be receiving a true multiple-factor Canadian equity ETF.
*Data shaded in light grey have a t-stat greater than 2, which indicates a statistically significant result Sources: MSCI, AQR Data Library
A number of readers have asked me what I think about Paul Merriman’s Ultimate Buy-and-Hold Portfolio. It sure does have a nice ring to it (placing the word “ultimate” before anything tends to have that effect). Merriman believes that you can increase the expected return of a simple Couch Potato portfolio by adding more small-cap and value companies to the mix. This is not a new idea – for decades now, academics have known about the historical small-cap and value premiums. Notable fund companies, like Dimensional Fund Advisors (DFA), have even created products based on their research.
Although Merriman’s articles are written from a US perspective, we can take his concepts and apply a Canadian spin to them. First, let’s take a look at a balanced Couch Potato portfolio (similar to my 40FI-60EQ model ETF portfolio). You can see that the equity mix is made up of 20% Canadian stocks, 20% US stocks, 16% international stocks and 4% emerging markets stocks.
Couch Potato Balanced Portfolio
Portfolios are rebalanced annually
We’ll then divide each equity region into four equal parts, consisting of large-cap blend, large-cap value, small-cap blend and small-cap value companies. Merriman usually includes real estate investment trusts (REITs) in his model portfolios as well, but I’ve excluded them so that we can view the small-cap and value effects in isolation).
Paul Merriman Balanced Portfolio
Comparing the performance of the two portfolios, we find that the Couch Potato portfolio has outperformed the Merriman portfolio over the 1, 3 and 5 year periods ending December 31, 2015. Both portfolios performed similarly over 10 years. The Merriman portfolio started to shine after 15 years, beating the Couch Potato portfolio on average by about 1% each year.
Portfolio Performance: January 2001 to December 2015
Sources: MSCI Indices, FTSE TMX and Russell indices courtesy of Dimensional Returns 2.0
There are a few insights that can be gained from this example. First, 15 years is a long time to wait for higher expected returns (with absolutely no guarantee of higher returns than the index). There is a huge behavioural argument against straying from the index for any active strategy.
Second, Merriman’s portfolio is much more complex than the Couch Potato portfolio. It contains 12 additional holdings, which must be managed as new cash is added to the portfolio and rebalancing opportunities arise. ETFs that have a similar value and small-cap tilt may not even be available to DIY investors.
Third, these figures are before any fees or taxes. If Merriman’s portfolio could be theoretically constructed using readily available ETFs, the ongoing costs would likely be higher than a Couch Potato portfolio.
What if I still want to invest like Paul Merriman?
For DIY investors, I always recommend keeping things simple and sticking with a Couch Potato portfolio. Trying to piece together the necessary ETF parts like a mad scientist could result in a portfolio abomination. Much like Victor Frankenstein, you may end up abandoning your monster shortly after its creation.
If you have an advisor that has access to DFA funds, there is a relatively easy way to create a Paul Merriman portfolio. For each equity region, simply have your advisor mix about 1 part broad-market ETFs with 2 parts DFA Vector Funds – by doing this, you’ll end up with a decent Merriman clone. I’ve included the weights of the indices below – you’ll notice these are very similar to the model DFA portfolios that some of our clients invest in.
DFA Balanced Portfolio
The DFA portfolio performance below is nearly identical to the Merriman portfolio performance. I’ve also included an additional graph showing the growth of $1 for each of the portfolios. The blue line representing the DFA portfolio is barely distinguishable from the brown line representing the Merriman portfolio.
Sources: MSCI Indices, DFA, FTSE TMX and Russell indices courtesy of Dimensional Returns 2.0
Dan Bortolotti’s recent blog post raised a number of questions from his readers concerning the impact of foreign withholding taxes within a corporate account. This is a hot topic, as many successful professionals are choosing to save within their corporation. Couch Potato investors often allocate 40% or more to foreign stocks, so it’s important for them to grasp these tax concepts before implementing their own portfolio.
Foreign interest income vs. foreign dividend income
The taxation of foreign income is often lumped into the “interest income” category, but this is not entirely accurate. Foreign interest income (the kind that is generally not subject to foreign withholding taxes) is taxed in a similar manner to Canadian interest income in a corporation. So holding a tax-efficient global bond fund in your corporate account should be just fine.
Foreign dividend income, on the other hand, can affect the amount of corporate taxes that are refundable when dividends are paid to you as a shareholder. For Couch potato investors, this foreign dividend income is typically received on a quarterly basis from your US, international and emerging markets equity ETFs. Foreign dividends are not specifically the issue – it is technically the foreign non-business income tax credit that throws a wrench into the refundable tax calculation.
In order to better understand the taxation of foreign dividend income in a corporation, we’ll start with the calculation of Part I tax, and move to the calculation of the refundable portion of Part I tax. We’ll then follow the dividend income out of the corporation and into the personal hands of the shareholder in order to calculate the overall taxes paid. To make the math easier, we’ll use $10,000 as our foreign dividend income figure, and assume a 15% withholding tax rate on the income (or $1,500).
Part I tax calculation
Similar to the corporate taxation of interest income, there is a base federal tax amount of 38%, along with an additional refundable tax of 6.67% (this has been increased to 10.67% in 2016). A federal tax reduction of 10% is then applied, and the foreign non-business income taxes paid are offset by the foreign non-business income tax credit of 15%. This results in Part I tax payable of 19.67% (38% + 6.67% - 10% - 15%).
Once we include provincial tax of 11.5% (for an Ontario corporation), our total taxes payable increase to 31.17% (19.67% + 11.5%). As we had initially paid 15% foreign withholding tax on the dividend income, this amount should also be included in order to calculate our total taxes. This equals 46.17% (31.17% + 15%), which is the combined federal/provincial tax rate for passive investment income earned within an Ontario corporation in 2015 (this amount is increasing to 50.17% in 2016).
Part I Tax Calculation
Source: CCH Corporate TaxPrep Software
Refundable portion of Part I tax
A portion of Part I taxes are refundable when dividends are ultimately paid out of the corporation to the shareholder. For interest income, the refundable amount is 26.67% (increasing to 30.67% in 2016). In our example below, the tax refund is only 15.24% of the dividend income. As mentioned earlier, this difference is due to the foreign non-business income tax credit. The refundable amount of tax would change depending on the withholding tax rate levied on the foreign dividends (for example, if you held an international equity ETF that withheld 12% instead of 15%, the refundable amount would differ).
Refundable portion of Part I tax calculation
Personal Tax Calculation
Of the $4,617 of total taxes paid on our $10,000 of foreign dividend income, $3,093 is non-refundable, and $1,524 is refundable when sufficient dividends are paid out to the shareholder. Since the after-tax corporate income is $5,383 ($10,000 - $3,093 - $1,524), there is currently $6,907 available to distribute to the shareholder ($5,383 after-tax corporate income + $1,524 refundable taxes).
If we assume that the distribution is in the form of a non-eligible dividend paid to an Ontario resident in the highest tax bracket, their personal taxes would be $2,772 in 2015 ($6,907 non-eligible dividend × 40.13% tax on non-eligible dividends). This would leave them with $4,135 of after-tax income ($6,907 - $2,772). I’ve illustrated the concepts in the chart below (adapted from Jamie Golombek’s 2014 article).
Foreign dividend income earned in a corporation in Ontario in 2015
Sources: Adapted from In Good Company: Retaining investment income in your corporation, Deloitte 2015 Top marginal income tax rates for individuals
The overall taxes paid on the $10,000 of foreign dividend income was $5,865 ($3,093 non-refundable corporate tax + $2,772 personal tax) or 58.65%, which is 9.12% higher than the top 49.53% tax rate in 2015 which would apply for an Ontario resident that earned the foreign dividend income personally.
This would suggest that an investor may be better off investing in foreign equities outside of their corporate account (i.e. in personal non-registered accounts, RRSPs, TFSAs, etc.). For investors who are comfortable with swap-based ETFs (such the Horizons S&P 500 Index ETF (HXS)), this may also be a suitable option, as the fund does not distribute foreign dividend income, and will therefore avoid foreign withholding taxes and the offsetting credit.