On June 11, 2013, First Asset released a new short-term bond ETF comprised entirely of strip bonds. It seemed like an odd choice at the time, seeing as there were already many short-term bond ETFs available to Canadian investors. Relative to the existing products, the First Asset 1-5 Year Laddered Strip Bond Index ETF (BXF) was expected to give investors a leg up when they held the ETF in their taxable accounts (Dan Bortolotti discusses the reasons for this in his blog post Why Use a Strip Bond ETF?).
Has this been the case in practice? Although it is too early to compare the after-tax returns for the 2014 tax year, we do have access to six months of data from July 2013 to December 2013. While I admit this is an extremely short time frame, it should give us some insight into whether the strip bond ETF has been more tax-efficient than other plain-vanilla bond ETFs.
Using the same methodology found in our white paper, I’ve calculated the after-tax returns and the tax cost ratio of various short-term bond ETFs. The results were not surprising; the strip bond ETF had a higher after-tax return and a lower tax cost ratio (which is a good thing) relative to the other ETFs. It also had a higher before-tax return, but this may be a result of its higher duration and First Asset’s no management fee promotion over the period.
Before deciding on which bond ETF to purchase, it is important for taxable investors to understand the impact that improper product location can have on their after-tax returns. Bond ETFs that trade at a premium to their par value (such as XSB, ZPS, VSB and CLF) should be restricted to tax-deferred and tax-free accounts. Strip bond ETFs (such as BXF) may be a more tax-efficient solution for investors who hold bond ETFs in their taxable accounts.
Dividend reinvestment plans (or DRIPs for short), allow investors to use their dividends to automatically purchase additional shares in the same ETF. The arguments in favour of using DRIPs usually go something like this:
Now I doubt anyone will argue with the benefits of reinvesting your dividends over time (rather than spending them). The question is, are DRIPs really necessary or could you just occasionally invest the accumulated cash (especially if you are saving regularly and have to place some trades anyways)?
To help answer this question, I’ve run the numbers to show what return an investor would have earned had they invested their dividends from the iShares Core S&P/TSX Capped Composite Index ETF (XIC) at the end of each year, compared to an investor who set-up a DRIP instead.
In years when market returns were positive, the DRIP investor had higher returns than the non-DRIP investor. In years when market returns were negative (such as 2008 and 2011), the DRIP investor had lower returns than the non-DRIP investor. Over ten years, both investors ended up with about the same return.
Although this is just one example (and does not include the annual $10 trading commission for the non-DRIP investor, nor does it assume they earned any interest from their idle cash), it helps to illustrate the point that investors should be focusing their attention to more important investment decisions that are likely to have a bigger impact on their overall success (such as their savings rate, expenses, risk, fees, taxes and behaviour).