When life gives you lemons, make lemonade. That’s how our team in Toronto has been reacting to the recent market volatility. In the context of this common phrase, the lemons are the stock market losses and the lemonade is the deferred capital gains taxes. Shortly after announcing our company’s new tax loss selling software, we initiated the following tax loss selling trades for a few of our clients.
September 30: Switched the DFA Canadian Vector Equity Fund Class F (DFA600) to the DFA Canadian Core Equity Fund Class F (DFA256).
By switching from the primary fund to the secondary fund, we realized the capital losses while maintaining exposure to the Canadian stock market. The trades settled on October 1 (T + 1). **Note: Generally, ETF and stock trades settle on T+3**
October 2 to October 31:
During this 30 day period, we held onto the secondary fund (DFA256) in order to avoid the superficial loss rules (which would take effect if we switched back to the primary fund too early).
One risk of switching from the primary fund to the secondary fund is that the secondary fund may lag the primary fund during the 30 day period. In this particular instance, the primary fund dropped by an additional 6.22% during the holding period, while the secondary fund only dropped by 4.03%. In other words, the clients received a boost in their returns because of the switch, which ended up being worth $1,429, $2,090 and $2,008 respectively (relative to if we had simply done nothing). Please keep in mind that the opposite scenario could have also occurred (which is why it is so important to choose secondary funds that have a low expected tracking error relative to your primary fund).
October 31: Switched the secondary fund (DFA256) back to the primary fund (DFA600).
As these trades settled on November 3 (T + 1), we avoided the loss being deemed as superficial. These trades also triggered more capital losses. I know it may sound like a sour outcome, but it simply allowed us to make more lemonade. In our opinion, a worse situation would have been if markets had fully recovered during those 30 days. Upon switching back to the primary fund, we would have triggered capital gains that may have offset some or all of the capital losses that we just realized.
By the end of the process, our three clients realized total capital losses of $8,013, $10,722 and $10,560 respectively. They can use these losses to offset gains in the current year, and then carry them back up to 3 years. If they have no gains to offset them with, they can carry them forward indefinitely. There was also the added benefit that the secondary fund outperformed the primary fund during the 30 day period.
The BMO Discount Bond Index ETF (ZDB) has been slow to gather assets since its launch in early 2014. This may be due to investor inertia or confusion over the reasoning behind holding discount bonds. There are generally two situations in which an investor may want to consider investing in ZDB rather than the more popular BMO Aggregate Bond Index ETF (ZAG):
With bond yields hovering near record lows, some investors have opted to hold bonds in their taxable accounts and stocks in their RRSP accounts. The issue with this strategy is that lower bond yields do not necessarily mean lower bond coupons. ZAG and ZDB both have a yield-to-maturity of 2.3% (which is the best estimate we have of their future before tax returns). But ZAG has an average taxable coupon of 3.9%, while ZDB has an average taxable coupon of 2.3%. All else equal, an investor would be expected to pay less tax and have higher after-tax returns if they held ZDB rather than ZAG in their taxable accounts.
For investors that hold the same mix of bonds and stocks in their RRSP and taxable accounts, using ZAG in the RRSP and ZDB in the taxable account will also likely result in higher after-tax returns (all else equal).
As most investors know, “all else” is not always equal. The selection of discount bonds in the Canadian marketplace is slim pickings, making a discount bond ETF like ZDB more exposed to corporate issuer risk than a broad market bond ETF like ZAG. For instance, ZDB holds over 3% in Telus corporate bonds, whereas a typical bond ETF would have less than a 1% allocation to the same issuer.
If you hold all of your bonds in an RRSP account, it makes little sense to invest in ZDB. A plain-vanilla bond ETF like ZAG would be the preferred choice, due to its increased diversification.
The race to the bottom continues as Vanguard Canada recently lowered the fees on 11 of their ETFs. The cost that investors will pay to construct a balanced portfolio of Vanguard ETFs is now just 0.13% (the same cost as a similar portfolio from iShares, and slightly cheaper than one from BMO).
iShares and BMO have also taken action to improve the tax-efficiency of their international equity ETFs by holding the underlying securities directly, while Vanguard continues to use a less tax-efficient “wrap” structure (choosing to hold US-domiciled ETFs instead). This structure leads to an additional layer of non-recoverable foreign withholding tax (for more information, please refer to our white paper, Foreign Withholding Taxes).
In the chart below, I’ve constructed balanced portfolios from the three companies and estimated their total costs (including foreign withholding taxes). The costs have been calculated separately for RRSP/TFSA accounts and taxable accounts.The results indicate that the iShares portfolio is still slightly cheaper in both cases by about 0.04%, although I would call this a draw. Canadian investors will be paying low costs no matter which plain-vanilla ETF they choose.
It’s finally here! While many Canadians were gearing up for the much anticipated iPhone 6 launch, I was patiently awaiting an upcoming portfolio management software release: the PWL Tax Loss Selling Report.
PWL advisors can now generate a report that shows all non-registered client accounts that have unrealized capital losses. Any capital losses realized must first be used to offset capital gains realized in the current tax year; they can then be carried back up to three years (or carried forward indefinitely). This allows investors in relatively high marginal tax brackets to defer taxes and possibly realize them at a more advantageous time.
The report was inspired by Larry Swedroe’s tax loss selling rule of thumb. His rule states that an investor should consider realizing a loss if it is at least $5,000 and at least 5% of the book value.
For example, suppose Other Barry purchased the DFA Canadian Vector Equity Fund Class F (DFA600) for $70,730. On September 30, 2014, the fund had dropped in value to $65,342.53 (resulting in an unrealized capital loss of $5,387.47). This loss represents a 7.62% drop in the book value ($5,387.47 ÷ $70,730 = 7.62%). In this case, both of Swedroe’s tax loss selling thresholds have been met. The generated report will now include Mr. Barry’s holding as a potential tax loss selling candidate.
Know when to fold ‘em
The decision about whether to realize a capital loss depends on the investor’s particular tax situation (my colleague, Dan Bortolotti, wrote about this topic in a recent blog). Once the decision has been made to realize the loss, a replacement security must be chosen (in order to maintain similar market exposure). I would encourage advisors and DIY investors to have a tax loss selling plan in place prior to implementing their portfolios.
I’ve included the tax loss selling pairs below that we use with our PWL clients, as well as the monthly tracking errors of the underlying indices. As discussed in our white paper, Tax Loss Selling, tracking error is the standard deviation of the differences in the monthly returns of the underlying indices. A low value indicates that the indexes have tracked each other closely in the past.
Suppose the advisor decides to realize the loss for Mr.Barry. He would place a trade to switch all units of the DFA Canadian Vector Equity Fund Class F (DFA600) to the DFA Canadian Core Equity Fund Class F (DFA256). The trade would settle on October 1 (trade date + 1 business days) and would need to be held for at least 30 days before it was switched back to the original holding (in order to avoid being deemed as a superficial loss). In this example, the replacement fund would need to be held by the investor from October 2 to October 31 (30 days). If the advisor switched back to the original fund on October 31, it would settle on November 3 (trade date + 1 business days), avoiding the superficial loss rules. ***Note: Most ETFs and stocks settle on T+3***