The recent rate cut by the Bank of Canada has continued to push bond yields lower. The yield-to-maturity on the iShares Canadian Universe Bond Index ETF (XBB) has dropped from 2.22% to 1.70% since the beginning of 2015 (this figure is as of January 28, 2015, and before fees and taxes). Due to the tax-inefficient nature of most bond ETFs, the after-tax returns for these products are expected to be considerably lower when held in taxable accounts.
Canadian ETF providers have been busy releasing more tax-efficient bond ETFs to mitigate this problem. The Horizons CDN Select Universe Bond ETF (HBB) is one such product. This ETF uses a total-return swap structure, which effectively converts the interest payments (which are taxed at the investor’s marginal tax rate), into deferred capital gains (which are taxed at only half the investor’s marginal tax rate, and only when the ETF is ultimately sold). Due to this advantage, HBB would be expected to have higher after-tax returns than a traditional bond ETF, like XBB.
While the tax benefits of HBB sound enticing, this ETF will likely shine more when bond yields are much higher than they are today. With current interest rates as low as they are, a GIC strategy might be expected to generate similar after-tax returns to HBB without the added complexity.
To illustrate what I mean, let’s compare two scenarios – one taxable investor who allocates $100,000 to HBB, and another investor who allocates $100,000 to GICs. Both investors are assumed to have a marginal tax rate of 50% (the highest in Canada). The yields are expected to remain constant throughout the holding period.
In this example, the investor would have an expected before-tax return of 1.38% (1.70% yield-to-maturity – 0.17% MER – 0.15% swap fee). The expected return is in the form of deferred capital gains (which are taxed at half the investor’s 50% marginal tax rate on liquidation of the ETF). I have assumed all the growth is reinvested each year. However, I’ve included a fourth column, Market Value Post-Liquidation, which shows the effect of an investor who sells the ETF at the end of any given year over the time horizon.
Over a 10-year holding period, the market value of the ETF would be expected to grow to $114,695 before-tax. The capital gain realized on the sale would be $14,695, at which time half would be taxable at 50%. The taxes payable would be $3,674 ($14,695 × ½ × 50%), resulting in a post-liquidation value of $111,021 ($114,695 – $3,674).
The other investor prefers to keep it simple, and instead invests $100,000 in a boring 5-year GIC paying 2.15% interest annually (this was the highest rate available through our brokerage at the time of writing). The interest is taxed at 50%, with the after-tax proceeds being reinvested at 2.15%.
By the end of the 10-year holding period, the GIC is worth $111,285 after-tax – which is $264 more than in the first scenario ($111,285 – $111,021).
This blog post is not meant to downplay the tax-efficiency of HBB’s structure. HBB would still be expected to have a higher after-tax return than a traditional broad market bond ETF (such as XBB), which is arguably a more fair comparison. However, for a taxable investor who does not require liquidity and prefers to keep things simple while taking less risk, a GIC is also a suitable option—and might even turn out to deliver a better after-tax return.
Rob Carrick wrote an article late last year that suggested four actively managed mutual funds which may be worth a look by open-minded DIY investors. All four funds had beaten the S&P/TSX Composite Index’s 8% return over the last 10 years (as of October 31, 2014). Three out of four of the funds had even crushed the index return since their inception.
Without more information, it would be difficult for DIYers to determine whether the outperformance was merely the result of tilting the portfolio towards known risk factors (such as the small cap or value factors), or if the managers had any skill that may resemble alpha. By running 3-factor regressions on the monthly returns for each fund since inception, we can better understand what factors are driving their returns.
Since July 1991, the fund has outperformed the index by +1.00%. After the fund returns are put through the wringer, we find that most of the excess returns are a result of the fund’s value tilt over the period (HML coefficient of 0.29). The true alpha of the fund drops from 1.00% to -1.17% (almost identical to the fund’s MER of 1.21%).
With annual outperformance relative to the index of +1.49% per year since May 1994, this fund would appear to be adding value for investors. Unfortunately, when we stress test the returns since inception, the alpha drops from +1.49% to -1.59% (once again, very close to the annual MER of 1.49%). Similar to the Mawer fund, most of Leith Wheeler’s excess returns came from its tilt towards the value factor (HML coefficient of 0.32).
This fund is already starting underwater with a negative alpha of -0.15% per year since inception. Although this doesn’t seem so bad (considering the fund has a cost of 1.38% per year), a 3-factor regression exposes the true alpha to be an even lower -2.20%. Once again, the value factor helped the fund achieve performance that was better than expected (with an HML coefficient of 0.33).
This was the only fund that had a positive alpha before and after running the 3-factor regression. The +1.16% alpha dropped to +0.50% per year after the regression results were in (for those of you who are interested, I subsequently ran a 4-factor regression with the additional momentum factor, which dropped the alpha to -0.15% per year).
Once the returns are put through a 3-factor analysis, most of the funds’ alpha disappears and even turns negative. Even though this analysis may seem somewhat sophisticated, it serves no useful purpose in determining which funds or risk factors will outperform in the future. It does suggest that if you are looking to add a value tilt to your portfolio (in order to increase your expected returns), there are probably cheaper ways to do this using low-cost ETFs, rather than paying for traditional active management.