Sunday, 30 November 2008

ETF and Mutual Fund Distributions Explained

Investors who own ETFs and mutual funds in taxable accounts (i.e. this does not apply to tax-protected accounts such as RRSPs) may be surprised and puzzled this year to receive T3 tax slips that show capital gains to be reported on their income tax return. After all, in 2008 stock markets had one of the worst years in living memory with the TSX down 35%. How could there be any gains one might ask?

Even in normal years of market advances, an investor may wonder why there are taxes to be paid if none of the investment was sold and no cash received.

The explanation revolves around distributions. Confusion arises because the word distributions is used to refer both to cash paid out to investors and to income attributed to investors for tax reporting purposes. In both cases, distributions consist mainly of capital gains, interest and dividend income generated during the year by the stock or bond holdings within the fund.

All Income Taxed as if Received by Investors
All ETFs and most mutual funds are structured as trusts, which means that to minimize taxes they pass along all income to investors to be taxed in the investors' hands. "Pass along" often means an actual cash payment to the investor but it may not.

Income Reinvested Automatically by Mutual Fund is Taxable
Mutual funds offer investors who want to reinvest income the convenient optional service of automatically buying more fund units with the profits instead of going through the complication of sending out cash only to have the money sent back to buy more units. The investor never sees the cash but receives the profits so it should not be disappointing to be required to pay taxes on the profits.

In the case of ETFs, interest and dividends are always paid in cash to investors either monthly, quarterly, semi-annually or annually. There is no option to have this income automatically reinvested as with mutual funds. The Managing Taxes document from iShares Canada explains why.

Cash Distributions May be Boosted by non-Taxable Return of Capital
It happens fairly often that funds distribute more than their income in a year. The excess is in effect paying back some of the investor's original investment and is termed a Return of Capital. This is not taxable.

Taxable Capital Gains When the Fund Sells: Investor Sees no Cash
Capital gains (or losses) arise when the fund sells and makes a profit during the year; the investor has not sold anything, the fund has. The net of all the sales during the year is calculated by the fund and the capital gains are attributed to the investor for purposes of tax reporting. Such gains are not usually paid out in cash to the investor; instead they get reinvested within the fund through new purchases.

The TSX had reached a peak in mid-June 2008, so stocks sold within a Canadian equity fund up to that point could well have made a capital gain and if few stocks were sold at a loss during the subsequent downturn before the end of the year, the fund might be reporting a net capital gain for 2008. That does turn out to be the case for instance, with the popular iShares Canadian Large Cap 60 Index ETF (symbol XIU). A press release of Dec.24 says XIU has generated a reinvested distribution of $0.14652 per share, which investors will soon see in box 21 on a T3 slip from their broker to be included on their tax return.

Taxable Capital Gains When the Investor Buys(!)
An investor who buys a fund late in the year just before the year-end capital gains distribution can end up paying tax for gains made much earlier in the year. Funds use the list of owners as of a certain date (termed the record date) to parcel out the year's gains, most often December 30th. The T3 the investor receives tells the tale. It may be better to defer the purchase till the new year. Fund companies normally publish year-end distribution estimates in advance of the record date so that investors can avoid the nasty surprise if a big capital gain is in the offing.

Taxable Capital Gains When the Investor Sells: Investor Sees Cash
A separate taxable capital gain (hopefully! or perhaps a loss) occurs when the investor sells all or part of a holding in a fund and the proceeds exceed the net purchase cost. The investor will NOT receive any T3 tax slips from the fund company to use on his/her tax return. It is up to the investor to calculate and report the gain.

Additional Info:
ETFs - iShares Canada Distribution History links for each fund - e.g. for XIU
Claymore Canada Tax Information Guide for 2007 (2008 tba) covering all its funds

Mutual Funds - follow links to fund companies at and look for Tax or Distribution info at each company's site; a typical handy guide is Mackenzie's Mutual Fund Tax Guide

As always, this post is not to be taken as advice. If you are unsure how to handle distributions, contact an accountant or other financial professional.

Thursday, 20 November 2008

ETFs - What are They Good For?

ETFs are in the news these days. Jonathan Chevreau's November 6th column at the National Post described the curious situation of significant net withdrawals in September and October by Canadian investors from mutual funds while certain Exchange Traded Funds (ETFs) saw large net purchases.

Their being in the limelight does raise the question of what ETFs are, their strong and weak points and why they might be attractive to an investor.

What are ETFs?
Exchange Traded Funds are funds that hold numerous individual stocks or bonds. ETFs are bought and sold as shares on stock exchanges (thus the name). Each share owns a tiny part of dozens, hundreds or even thousands of individual stocks or bonds. ETFs are built to copy the compostion of an index, such as the TSX60, the S&P500, the Dow Jones or some other index, such as the UK FTSE, the Eurozone, the Far East, commodities, currencies, large/small companies, or sectors such energy, mining, financials, real estate etc.

The number and variety of ETFs is growing steadily. As of early November 2008, there are over 800 US-exchange traded ETFs and 60-odd Canadian-traded ETFs available to a Canadian investor through any discount broker.

More background:
Strengths and Weaknesses of ETFs
The following chart should be self-explanatory, except for the last line, which is deliberately repeated! An index fund will necessarily do no better (actually, a little less by the amount of costs the fund incurs) than the index it tracks, the average of that particular market. That is bad in the sense that you will never get rich quick through amazing returns. But it is good in the sense that the vast majority of mutual funds over any extended period of years under-perform the market (see the latest results from Standard and Poor's SPIVA Canada Scorecard where for example, only 6% of activle-managed Canadian equity mutual funds outperformed the TSX index over the past 5 years ).

What ETFs are Best Suited For
Given their characteristics in comparison to individual stocks and bonds and mutual funds, here is how I believe ETFs can most be most useful to an individual investor:
  • Buy and hold passive investing with low time and attention needed for portfolio management
  • Portfolio-oriented investing where diversification, deliberate asset allocation with non-overlapping funds, infrequent rebalancing (max once a year) and risk control are key to the investment approach
  • Long-term investing
  • Fixed income bond holdings (and like all fixed income, ideally held within a registered account to minimize tax from interest income)
  • Equity holdings in taxable accounts
  • Larger new amounts to add to a portfolio (e.g. a $10 commission on a $1000 purchase is 1% initial cost, about the max I would accept for myself)
  • Larger market cap equity holdings and developed country markets, since these are the most efficient and where it is most likely that mutual funds will not outperform; conversely, small caps and emerging markets are where mutual fund managers have better chances of outperforming
Whether it is the inherent qualities of ETFs or some other factor that caused people to buy them while mutual funds were being sold off recently is open to debate but their value and usefulness is certain.

Thursday, 13 November 2008

Time to Put Readers to Work ... and There's a Reward!

There isn't only one answer or source of information when it comes to investing. A diversity of views and good ideas can come from many sources, both professional and amateur.

This blog would like your input and as a reward, two people selected randomly from those who answer, one for each category, will receive a copy of Dr. Sherry Cooper's well-regarded recent book The New Retirement. See reviews on Chapters Indigo, Amazon, CanadianFinancialDIY.

Your task: in a Comment at the bottom of this posting, either,
  1. Name either your favorite investing book and a one line summary on why it is useful to you as an investor, or
  2. Name and provide a link to your favorite online investing website, whether it's a blog, news site, data site etc and again say in one line why it is useful.
That's it.

I will use the responses to build some permanent lists and links to make this blog more useful for everyone.

Use something other than "anonymous" as your comment name so I can get in touch with the winners and mail out the book, which will require having the winners' postal address. You will not be put on a mailing list or be receiving ads, junk mail or anything else except the book. The contest closes in a week from this post on November 13th, i.e. midnight on November 20th.

Thursday, 6 November 2008

Not Everything is Down! Some Stocks are Up!

The seemingly unceasing gloomy financial news and plummeting stock markets could easily cause one to conclude that every stock has lost ground. Take heart, there are some winners in the markets!

The two screenshots below show the results of searching through the Toronto and New York stock exchanges for any stocks that have not gone down over the past year and for 2008 to date, i.e. that have survived the general meltdown. In both cases, I also specified that the company would have to be a reasonable size with active trading to eliminate the wacky, probably anomalous holdings.


USA (NYSE only)

In both markets, there are many companies, though they are decidedly a small minority compared to the overall number in the market, that have held their ground or even advanced significantly. Moral of the story - even in the worst of times like right now, there are still winners. And some may surprise - note some financial companies doing well, like Bank of America (NASDAQ symbol: IKL) in the US and Fairfax Financial (TSX symbol: FFH) in Canada.

The trick is, of course, finding them in advance (since finding them after the fact is like getting to the scene of a great dinner party the morning after - there may be a few leftovers but the good stuff has already been eaten).

Finding the winners requires research. A good way to start is to use the stock screeners with which I zeroed in on this year's year-to-date winners. Stock screeners let you specify criteria, for price, company size, sector, growth rates, profitability, usually along with analyst ratings. They allow searching through ETFs and mutual funds too. The best free one I know of for the Canadian market (it covers US markets too) is at GlobeInvestor. For US markets, an excellent free screener is Google Finance's, which has visual sliders that tell you how many companies are left as you go along. When you sign up with a discount broker, there is a screener tool available online as part of the package. In the today's example, it is BMO Investorline's, where I happen to have an account. BMOIL uses the enhanced Gold version of GlobeInvestor.

What your research aims to uncover in order to identify those winners is the million dollar question, easy to say in principle but very hard to assess in reality and a fine topic for future posts. For today, it's enough to remind ourselves to stay the course and not lose heart.