In our latest white paper, After-Tax Returns, Dan Bortolotti and I explain our methodology for calculating the after-tax returns of Canadian-domiciled ETFs. We were surprised to learn that funds with higher before-tax returns and similar investment strategies could have their fortunes reversed when their after-tax returns were compared instead.
For example, if we compare the before-tax returns of the TD Canadian Index Fund e-Series (TDB900) and the iShares Core S&P/TSX Capped Composite Index ETF (XIC) over the past ten years, we find that investors would have been better served by opting for XIC over TDB900.
If we assumed that the investor held either fund in their taxable account instead (and paid the highest combined marginal tax rate on the income received), we would end up with an entirely different result. TDB900 would be the preferred holding in this case (mainly due to the significant capital gains that XIC distributed between the 2005 and 2007 tax years).
For those investors who are interested in calculating the historical after-tax returns for any Canadian-domiciled ETF, please feel free to download our PWL 2013 After-Tax Rate of Return Calculator. As always, please email us with any questions or comments.
Justin Bender: firstname.lastname@example.org
Dan Bortolotti: email@example.com
Tracking error, when referring to an ETF, is the difference between the ETF’s return and the return of the underlying index it is tracking. The ETF is usually expected to lag its benchmark index by at least its management expense ratio (MER), and sometimes more.
If we compare the 10-year annualized return of the iShares Core S&P/TSX Capped Composite Index ETF (XIC) to the returns of the S&P/TSX Capped Composite Index (its current benchmark), we end up with a very respectable annualized tracking error of -0.04% (7.93% minus 7.97%). This low tracking error appears too good to be true, since the fund paid management expenses of between 0.17% and 0.27% each year.
XIC vs. the S&P/TSX Capped Composite Index as of December 31, 2013:
The main reason for this difference is BlackRock’s choice of benchmark. Throughout the measurement period, XIC is compared to the S&P/TSX Capped Composite Index, even though it historically tracked the S&P/TSX 60 Capped Index prior to November 15, 2005. This is disclosed on their website, but can easily be missed.
BlackRock Canada Performance Disclaimer:
In order to create a more apples-to-apples benchmark for XIC, the returns of the S&P/TSX 60 Capped Index should be spliced together with the returns of the S&P/TSX Capped Composite Index. After doing this, the annualized tracking error has now increased to -0.20% (7.93% minus 8.13%). This seems much more in line with what an investor would expect to see.
XIC vs. the Spliced Canada Index as of December 31, 2013
Investors and advisors must be diligent when reviewing benchmark comparisons that have been illustrated by fund providers. In some cases the numbers may not be telling the entire story, and further analysis may be required.
Investment performance has always been a touchy subject for the financial industry. Portfolio rates of return are rarely disclosed, and investors are often left in the dark on how they are actually doing. Phase II of the Client Relationship Model (CRM II) is about to change all of that. Starting in July 2016, dealers and portfolio advisors will be required to provide performance reports to their clients every year.
The money-weighted rate of return (MWRR) was chosen by the Canadian Securities Administrators (CSA) as the industry standard for these performance calculations. Their rationale was that the money-weighted rate of return was more relevant to the individual investor. Other industry groups, such as the Portfolio Management Association of Canada (PMAC), requested that the CSA reconsider their decision, and instead allow dealers and portfolio advisors to use either the money-weighted or the time-weighted rate of return (TWRR). They argued that the time-weighted rate of return was a more appropriate method, as it allowed investors to directly compare their performance to suitable benchmarks and to other advisors and portfolio managers.
To better understand both sides of this debate, let’s look at a hypothetical investor who receives performance reporting using the money-weighted rate of return, but then attempts to compare it to an appropriate index return.
Money-Weighted Rate of Return Example
At the end of 2003, an investor contributes $100,000 to a Canadian stock portfolio managed by an advisor. After four years of stellar returns, the investor decides to place an additional $100,000 under their management. The financial crisis quickly unfolds, and the investor ends 2008 with only $189,600 (wiping out all previous gains and leaving them with less than their total investment).
Example: Transaction history for hypothetical investor
Shortly after year-end, the investor receives a performance report from their advisor, indicating that their 5-year annualized money-weighted rate of return is -1.78%1. They are not surprised by this figure, but decide to compare it to a suitable benchmark, the S&P/TSX Composite Index. To their horror, they find that over the exact same period, the index returned 4.15% on an annualized basis.
If we recalculate the investor’s return using the time-weighted rate of return method, we end up with a 5-year annualized return of 4.16%2 (almost identical to the benchmark return). But how can that be? The investor has clearly lost money – they are down $10,400.
The reason for this is because the money-weighted rate of return is more dependent on when the dollars are actually contributed or withdrawn from the portfolio. In the example above, the investor doubled the amount they had initially contributed right before the market declined, resulting in a lower return relative to the time-weighted rate of return. The results of this method often make more sense for the investor, as it is a better representation of how they have actually done.
The time-weighted rate of return ignores all contributions and withdrawals from the portfolio. In the example above, the investor’s bad luck or timing had no effect on their return. The calculation basically assumes that they invested $1 at the beginning of the period (with no further contributions or withdrawals). This method is ideal for comparing managers or funds to benchmark indices.
The CSA has stood firm on their decision, so it is up to advisors to familiarize themselves with both methods so they can explain them to their clients. In order to help with this task, I’ve posted several rate of return calculators (in the Calculators section of the blog) that use the Modified Dietz method (an approximate time-weighted rate of return). This will allow advisors and clients to calculate a more appropriate return for benchmarking purposes.
1 MWRR =
Source: Weigh House Investor Services: Calculate Your Portfolio’s Return
2 TWRR = [(1 + 0.13) × (1 + 0.27) × (1 + 0.17) × (1 + 0.09) × (1 + (-0.33))](1/5) – 1 = 4.16%