It’s been almost three years since Dan Bortolotti and I released our popular Tax Loss Selling white paper. Throughout the paper, we showed investors how to implement a disciplined tax loss selling strategy, using Canadian-listed ETFs. Near the end of the paper, we even provided suggested ‘tax loss selling pairs’ (which consist of a primary ETF and a secondary ETF that is very similar to the initial holding). Our process proved to be very useful after the recent Brexit announcement, as we were busy realizing losses on the international equity ETFs in our taxable client accounts.
Although most of the advice contained in the paper is still relevant, new ETFs have been released over the years, triggering us to update our recommended tax loss selling pairs. We have also updated the monthly tracking errors of the underlying indices over the past ten years (from 2006 to 2015). The ‘tracking error’ in this context is the standard deviation of the differences in their monthly returns – just remember that a lower tracking error is generally preferred for tax loss selling purposes).
Sources: BlackRock Canada, Vanguard Investments Canada Inc., MSCI Indices, Morningstar Direct, Dimensional Returns 2.0
Canadian Stocks: We’ve stuck to our guns on this one. The Vanguard FTSE Canada All Cap Index ETF (VCN) remains our primary holding in client accounts. When markets get rocky, we’ll sell this holding and purchase either the iShares Core S&P/TSX Capped Composite Index ETF (XIC) or the BMO S&P/TSX Capped Composite Index ETF (ZCN) (you’ll notice that the replacement ETFs track the same index). The tracking error of the underlying indices has been 0.33%, so the ETFs are expected to have similar risk and return characteristics going forward. Just be careful not to use XIC and ZCN as your tax loss selling pairs. The CRA has made it very clear that switching from one ETF to another that follows the same index will result in a denied capital loss.
Most tax loss selling advice recommends switching back to the primary ETF after holding the secondary ETF for at least 30 days (this avoids CRA’s superficial loss rules). We do not feel that this is necessary in most cases, as our secondary holdings are still great long term substitutes for our primary holdings. However, if after 30 days your replacement ETF is showing a significant loss, it may make sense to trigger a second loss by switching back to the original holding.
US Stocks: After the release of our paper, we didn’t come across many tax loss selling opportunities for US stocks (which was a good thing). We continue to use the Vanguard U.S. Total Stock Market Index ETF (VUN) as our primary ETF, but have been using the iShares Core S&P U.S. Total Market Index ETF (XUU) as our secondary ETF. At the end of 2015, XUU switched its underlying index from the S&P Composite 1500 to the S&P Total Market Index (which includes a whopping 3,843 stocks), so it is now even more similar to VUN (which tracks 3,624 stocks). The tracking error between the pairs has been extremely low, at 0.09%.
International Stocks: We’ve left the primary ETF as the iShares Core MSCI EAFE IMI Index ETF (XEF), but changed our secondary ETF to the Vanguard FTSE Developed All Cap ex North America Index ETF (VIU). VIU was released at the end of 2015, and holds the underlying stocks directly (making the ETF more tax-efficient than the past recommendation from our white paper).
You may notice the tracking error of 0.46% is higher than most of the other asset classes. This is expected, as the underlying MSCI and FTSE indices have different construction methodologies. The biggest difference is that FTSE considers South Korea to be a developed market, and includes it in their developed markets indices. MSCI is not as convinced, and still includes the country in their emerging markets indices. Once South Korea is added to the MSCI developed markets indices, the tracking error would be expected to decrease.
Emerging Markets: We have left our recommendations the same for this asset class. Our primary ETF is still the iShares Core MSCI Emerging Markets IMI Index ETF (XEC), and our secondary ETF is the Vanguard FTSE Emerging Markets All Cap Index ETF (VEE).
Similar to the international indices, the tracking error for the emerging markets indices has been noticeably higher, at 0.64%. It has the same issue as our international index pairs – MSCI considers South Korea to be an emerging market, while FTSE does not (and excludes it from its emerging markets indices). FTSE also includes a portion of China A shares within its emerging markets indices, which may be causing some of the increased tracking error.
Global Stocks: Many DIY investors are now using ETFs that track a combination of US, international and emerging stock markets. Even though the returns from the various regions may offset each other at times (resulting in less tax loss selling opportunities), there will still be moments when global stocks as a group plummet. For our primary global stock ETF, we would recommend using the iShares Core MSCI All Country World ex Canada Index ETF (XAW). When this ETF is down in the dumps, consider switching it to the Vanguard FTSE Global All Cap ex Canada Index ETF (VXC) in order to realize the capital loss. The tracking error has also been the lowest of the bunch, at 0.08%.
The MSCI EAFE Index is arguably the most popular international index on the block. Many active fund managers’ returns are benchmarked to this index (and the majority of them fail to outperform it). Couch potato investors also tend to allocate a portion of their portfolios to ETFs that track the MSCI EAFE or a similar index.
If we pop the hood on the MSCI EAFE Index, we can see that it currently allocates 63.8% to European companies, 35.4% to Pacific companies and 0.8% to Middle Eastern companies. These weights are free to fluctuate over time, based on the performance of the underlying currencies and stocks.
Underlying country weights of the MSCI EAFE Index
Source: MSCI Index Fact Sheets as of June 30, 2016
A reader recently asked me whether they should attempt to outperform the MSCI EAFE Index by allocating 50 percent to a Europe ETF and 50 percent to a Pacific ETF. Although this may sound like active management, many notable index investors, like Rick Ferri and Ben Carlson, have advocated this approach in the past. Most of their analysis indicates that a 50-50 split between European and Pacific stocks has historically outperformed the MSCI EAFE Index.
Whenever I read arguments in favour of tinkering with a plain-vanilla index approach, I like to run the numbers myself, both from a Canadian investor perspective and an overall portfolio perspective. To do this, I’ve created two balanced portfolios for comparison; one has a 20% allocation to the MSCI EAFE Index, while the other allocates 10% to the MSCI Europe Index and 10% to the MSCI Pacific Index. The portfolios are then rebalanced annually at the end of each year.
*Portfolios are rebalanced annually at year-end.
The results will likely surprise many readers. The returns were not only close, but identical for the 10 and 20 year periods. The 50-50 split portfolio outperformed the 100 percent EAFE portfolio since inception with a lower standard deviation, but the differences were immaterial. Also, the analysis did not factor in the additional capital gains taxes that would have likely been realized by taxable investors while rebalancing the Europe and Pacific component back to its 50-50 target. Based on the results below, I see no compelling evidence that suggests splitting the EAFE allocation has resulted in anything more than additional taxes and portfolio complexity.
*Portfolios are rebalanced annually at year-end.
Sources: MSCI, FTSE TMX Indices and S&P Down Jones Indices courtesy of Dimensional Returns 2.0