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Perfecting the Perfect Portfolio (Part II)

June 30, 2016 - 4 comments

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.

2015 Estimated Taxes

Portfolio 1 Shares Market Value ($) Taxes (2015)
Vanguard Canadian Aggregate Bond Index ETF (VAB) 15,664 $400,000 $5,613
Vanguard FTSE Canada All Cap Index ETF (VCN) 6,816 $200,000 $1,659
Vanguard FTSE Global All Cap ex Canada Index ETF (VXC) 15,111 $400,000 $4,917
Total   $1,000,000 $12,190
Portfolio 2      
BMO Discount Bond Index ETF (ZDB) 25,575 $400,000 $3,863
Vanguard FTSE Canada All Cap Index ETF (VCN) 6,816 $200,000 $1,659
Vanguard FTSE Global All Cap ex Canada Index ETF (VXC) 15,111 $400,000 $4,917
Total   $1,000,000 $10,440
Difference (2015)     $1,750

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%). 

By: Justin Bender with 4 comments.
  13/10/2017 10:51:44 AM
Justin Bender
@Melissa Yuan Innes: The example showed a savings of $1,750 on a $400,000 bond position (which would translate into a cost savings of about 0.4375% annually (not 4.375%...unfortunately ;)

I generally hold ZDB in taxable accounts when I want broad-market bond exposure (over less tax-efficient ETFs, like VAB). If VAB is currently in the red, this may be a good tax loss selling opportunity. For RRSP accounts, I generally hold the BMO Aggregate Bond Index ETF (ZAG), but other broad-market bond ETFs would be fine too (if you’re interested in which ETFs I hold in which accounts, please feel free to review the Model ETF Portfolios on my CPM blog, which are broken down by account type).
  09/10/2017 9:12:22 PM
Melissa Yuan Innes
Justin, the example you gave was a saving of 4.375%, which is considerable over time.
1. Do you recommend generally recommend selling VAB in order to switch to ZDB in a taxable account? (Painful, as VAB is in the red for me.)
2. What do you recommend for bonds in an RRSP or (less desirable) TFSA, if not ZDB?
Thanks, as always!
  16/01/2017 8:25:34 PM
Justin Bender
@Nik: ZDB should only be used in taxable accounts, as it is more tax-efficient (relative to it's sister ETF, ZAG). ZAG is slightly cheaper than VAB, and can be used as a substitute (there are minor differences, but nothing too drastic).
  10/01/2017 6:35:52 PM
Hey Justin,

Especially given the now lower MER of ZDB, why would anyone prefer VAB?

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