In my last blog post, I showed Couch Potato investors how they could reduce the foreign withholding tax drag in their RRSP accounts by holding US-listed ETFs. I’ll admit that the proposed ETF changes required investors to roll up their sleeves a bit, but the cost savings could not be ignored. But what if an investor wanted to implement the Couch Potato portfolio in a taxable account – is there any room for improvement?
It turns out there is. The Vanguard Canadian Aggregate Bond Index ETF (VAB) is not the best choice for taxable accounts. The fund holds bonds with a higher weighted average coupon than their weighted average yield-to-maturity (these bonds are also known as “premium bonds”). Ideally, taxable investors want to purchase bonds that have a yield-to-maturity equal to their coupon (referred to as “par bonds”). Or better yet, they would prefer bonds with a coupon that is lower than their yield-to-maturity (referred to as “discount bonds”).
Luckily, the BMO Discount Bond Index ETF (ZDB) was created as a solution to this premium bond issue. The fund purchases bonds that have much lower coupons than VAB, but about the same yield-to-maturity. Translation – same before-tax return, higher after-tax return. Let’s take a look at how substituting ZDB for VAB in a balanced Couch Potato portfolio would have fared last year.
The chart below compares the taxes paid on two portfolios. The first portfolio holds VAB while the second portfolio substitutes ZDB in its place. I’ve assumed that all ETFs were purchased at the end of 2014, and held throughout the 2015 tax year. The ‘Taxes (2015)’ column estimates the amount of taxes that would have been payable by an Ontario resident in the top marginal tax bracket during the year for each of the ETFs. Holding VAB instead of ZDB resulted in an additional tax bill of $1,750 during the year (or an additional cost of about 0.175% on the overall portfolio). The taxes would have increased further if bonds had made up a higher proportion of the investor’s overall portfolio.
Sources: CDS Innovations Inc., BMO ETFs, Vanguard Canada
BMO also recently announced that they have lowered the management fee on ZDB to 0.09% (from 0.20%), which is one more reason to favour ZDB over VAB in taxable accounts (VAB currently has a management fee of 0.12%).
The Couch Potato portfolio has it all – low fees, broad-diversification, and simplicity. There’s not a whole lot of room for improvement, but with a few tweaks, investors can lower their costs even further.
One such improvement can help mitigate the drag from foreign withholding taxes levied on dividends paid from US and other international companies. If we look at the Couch Potato model ETF portfolios, we find that they hold just a single foreign equity fund, the Vanguard FTSE Global All Cap ex Canada Index ETF (VXC). Pretty simple, right?
If we pop the hood of VXC, we find that it holds four US-listed ETFs, which together hold over 7,500 stocks from across the globe. This “wrap” structure is not such a big issue in a taxable account, but the additional costs become more apparent when the fund is held in an RRSP account (which is discussed in more detail throughout our Foreign Withholding Taxes white paper).
Underlying Holdings of the Vanguard FTSE Global All Cap ex Canada Index ETF (VXC)
Source: Source: Vanguard Canada Quarterly Portfolio Disclosure as of March 31, 2016
Although VXC’s wrap structure may not seem important at first, holding the underlying US-listed ETFs directly in your RRSP would be much more tax-efficient.
To help illustrate this concept, I’ve estimated the total cost of holding VXC (0.71%) versus holding the underlying US-listed ETFs directly (0.19%). By holding the US-listed ETFs directly, an additional cost savings of 0.52% per year can be expected (this estimate includes the lower expense ratios of the US-listed ETFs, as well as the lower foreign withholding taxes levied – however, it does not include the costs of currency conversion, which can be substantial if not carefully implemented).
For more information on how not to get hosed by the big banks on currency conversions, please read about the Norbert’s gambit strategy.
Estimated expense reduction of using US-listed ETFs in your RRSP
Sources: BlackRock Canada, MSCI Index Fact Sheets as of May 31, 2016
Although holding US-listed ETFs in your RRSP is not absolutely necessary for couch potato investors, it can lead to substantial cost savings over time. These benefits should first be weighed against other factors (i.e. lack of simplicity, additional trading costs, US estate taxes, etc.) before making a final decision on the appropriate plan of action.
Q: “Why do some people still use XEF/XEC vs. VIU/VEE, since both VIU and VEE are more diversified?”
As new ETFs are released, it’s natural for index investors to succumb to what I like to call “ETF envy”. I often witness it when an ETF provider lowers their fees below that of their competitors’ – this is usually met with investor excitement as they frantically switch their higher-cost fund to the lower-cost alternative. As one would expect, the higher-cost provider usually follows suit by lowering their fee to match.
This can be detrimental to an investor’s financial health if it causes them to realize unnecessary trading costs, bid-ask spreads and capital gains in pursuit of a temporarily superior product.
Hard-core index investors also tend to exhibit this behavior while in search of the most diversified ETF. If we base our decision simply on the number of underlying index holdings that an ETF tracks, Vanguard would beat iShares hands down (7,075 stocks vs. 5,766 stocks). However, it is important to dig a little deeper with our analysis to ensure we have not missed any subtleties that may impact our decision.
The inclusion of China A shares in FTSE indices
In May 2015, FTSE released several new emerging markets indices, which included a modest allocation to China A shares (about 5%). In November 2015, Vanguard began transitioning to these new indices, which currently include an additional 1,541 China A shares.
Although this may sound impressive, the 1,541 additional China A shares account for only 1.18% of the total developed/emerging markets allocation. To put this into perspective, for a balanced Couch Potato portfolio that allocates 20% to VIU/VEE, only 0.24% of your entire portfolio will hold the additional China A shares.
Sources: MSCI and FTSE Index Fact Sheets as of May 31, 2016 *77.43% MSCI EAFE IMI Index + 22.57% MSCI Emerging Markets IMI Index **80.03% FTSE Developed All Cap ex North America Index + 19.97% FTSE Emerging Markets All Cap China A Inclusion Index
MSCI on a slow boat to China
Although MSCI has not yet added China A shares to their indices, it is only a matter of time until they do (MSCI will be announcing their next China A share inclusion decision on June 14, 2016). MSCI has proposed an initial 5% partial inclusion of China A shares (or about 1.1% of their emerging markets index). If they move ahead with this proposal, it will take effect in June 2017. The initial allocation will be less than the amount FTSE started out with, but will likely include a larger number of stocks (which may in turn make XEF/XEC look more diversified than VIU/VEE).
In the end, there is no right or wrong decision. Both pairs of ETFs will provide adequate diversification for investors. MSCI and FTSE will eventually have a similar allocation to China A shares in their emerging markets indices, so any significant differences in weights or stock holdings is expected to be temporary.
In August 2014, BlackRock Canada announced that they were changing the investment strategy of the iShares Core MSCI EAFE IMI Index ETF (XEF) in order to reduce the overall amount of foreign withholding tax levied on the fund. XEF would no longer gain its international stock exposure by holding the iShares Core MSCI EAFE ETF (IEFA) (a US-listed ETF) – it would instead hold the underlying stocks directly.
Lately, I’ve spoken to numerous investors who feel that holding US-listed international equity ETFs, such as IEFA, is still the way to go (especially in RRSP accounts), due to the lower foreign withholding taxes levied. In order to dispel this myth, let’s compare the foreign withholding tax cost of our two similar funds, IEFA and XEF.
(Note: For this analysis, I’ve used the methodology from our white paper, Foreign Withholding Taxes, and summarized the results in the chart below).
Tax-Free and Taxable Accounts
The foreign withholding tax drag is higher in the tax-free (TFSA) accounts (0.69% vs. 0.26%) and taxable accounts (0.25% vs. 0.00%) for IEFA relative to XEF. Although IEFA has a lower expense ratio than XEF (0.12% vs. 0.22%) the 10 basis point advantage can’t compete with XEF’s more tax-efficient structure. Converting currencies in these accounts to purchase IEFA would also add additional cost and complexity to the portfolio. I think it’s safe to say that XEF is a slam-dunk for these types of accounts.
These next results were what really stood out to me. IEFA and XEF had almost the exact same foreign withholding tax cost (0.25% vs. 0.26%) when held in tax-deferred accounts (such as RRSPs or LIRAs). The only advantage of holding IEFA over XEF would be the slightly lower expense ratio (0.12% vs. 0.22%).
We’ll call this one a draw. Although IEFA is slightly cheaper before considering currency conversion costs, a few currency conversion errors can quickly tilt the analysis in favour of XEF. If you’re still debating which ETF to purchase in your RRSP account, please follow this simple advice:
Sources: 2015 BlackRock Annual Reports, MSCI Index Fact Sheets as of April 29, 2016