ETF Asset Allocation across RRSP, TFSA and Taxable Accounts

Many investors, including this blogger, whether by intent or happenstance, have their investments spread across multiple account types, such as RRSP (or a LIRA), TFSA and Taxable/Non-registered. As we advocate in this blog, the wise investor diversifies across different types of investments to maintain a portfolio asset allocation with the percentage breakdown specified to meet investment objectives - see example in our post on investment policy. A fundamental principle is that though the portfolio may span many accounts it should be managed as a whole, not as independent pieces. The next question then is - What is the best way to divide up the investments across the two dimensions of account type and asset type?

Key Portfolio Issues - Let's work through an example to see how it could look in practice, considering these factors:

• Canadian taxes - See our posts on the general principles to apply for income level and province, choice of RRSP vs TFSA vs Taxable account and RRSP vs TFSA critical differences,
• US and International withholding taxes - How this affects investments is explained in Pros and Cons of Cross-Border Shopping for ETFs; there is a worked-out example together with a link to a free downloadable spreadsheet to test other ETFs in the Cross-Border ETF Free Tool post
• RRSP, TFSA account limits - $5,000 per year for TFSA, which three years after startup, amounts to a total possible of only $15,000 and 18% of earned income for the RRSP (see TaxTips.ca here for details). Come January 1, 2012, the TFSA contribution limit will rise another $5,000.
• Rebalancing in future on a regular basis to keep the portfolio in line with the intended allocation

Our example portfolio contains $100,000, a nice round number that makes it easy to match up percentage breakdown and dollar amounts. Our portfolio uses the ETFs and breakdown in the Balanced Portfolio suggested in the just-released update edition of Gail Bebee's book No Hype: The Straight Goods on Investing Your Money.


1) RSSP and TFSA are the major accounts for the portfolio - The tax-free growth in both the TFSA and RRSP produces the best long run returns and that's where everything should go if possible. However, we assume for illustration purposes that the investor has run out of RRSP room and must also maintain a taxable account, which allows us to show what should go in there. We also assume that the person wants to use both a RRSP and a TFSA but of course the TFSA has a $15k contribution limit. A person in the highest tax bracket might want to concentrate everything in the RRSP.

2) Cash is split amongst all three account types to facilitate rebalancing. Possibly the cash may be handy for emergency needs and it can be put back into the account when it is in a TFSA (in the following calendar year) or a taxable account (anytime). Note that the Manulife Financial Investment Savings Account (MIP510), may face higher minimum purchase amounts from certain brokers though Manulife itself does not impose a minimum.

3) Highest tax rate interest bearing bond ETFs go in the RRSP or the TFSA where there is tax protection.

4) TFSA gets some bonds and some equity to facilitate rebalancing, since those are the assets most likely to move in different directions. Equities worldwide tend more to move in sync. It is far easier to do rebalancing trades within an account. Indeed, it is not permitted to transfer money into a TFSA to rebalance if the TFSA's contribution limit has been maxed out. Taking money out of the RRSP to rebalance to a Taxable account loses the tax advantage so that doesn't make sense. The Claymore 1-5 Year Government Bond ETF (CLF) is split between RRSP and TFSA since it has a bigger allocation and will be cheaper to rebalance considering trading costs. Similarly it is the larger iShares S&P/TSX Capped Composite Index Fund (XIC) that is split between the RRSP and the TFSA.

5) Taxable account gets ETFs with US and international holdings due to foreign withholding taxes that cannot be recovered.

The same principles would apply to other ETFs that can be used to construct the same or other portfolios. The percentage allocations may vary towards more or less fixed income or equities but the asset classes and the tax characteristics will be the same.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Dividend Initiators as a Stock Selection Concept

In his first feature article for the recently acquired Canadian MoneySaver, new owner Peter Hodson, formerly hedge fund manager at Sprott Asset Management, provides an intriguing idea for finding stocks that will pay off well in future. He goes so far as to state that this is the single best investing theme he has to offer after 25 years in the business. His principle: take a serious look at companies that declare their first ever dividend.

Why dividend initiation is significant
Hodson believes that initiating a dividend tells us the company: a) is doing well; b) has excess cash; c) is managed by a Board that respects shareholders and likely owns lots of shares itself; d) is likely to pay out a steady stream of stable or rising dividends for many years. That sounds sensible but how can we take the idea forward?

Finding first-time dividend payers
His article mentions two companies that have have recently declared their first dividends: Primary Corp (TSX: PYC) and DSW Inc (NYSE: DSW). To find others, we cannot unfortunately rely on that standard investor tool, the stock screener. We could find no screener with a first-dividend filter or even some proxy that would cleverly achieve that end. Instead our list below relied on the basic Internet tool that everyone knows, the Google search, where we searched for words such as "dividend, stock, initiate, first, Board".



Tracking and investigating the candidate stocks
Compiling a list is a start but not the end of the story. No doubt some of these companies and stocks look better than the rest and some may not look good at all.

Watchlist - A simple starting point is to set up a watchlist of the potential stocks, for example by using the GlobeInvestor My Watchlist (see screenshot below of the above list with a few of the customizations that the tool allows). It can contain both Canadian and US stocks and shows many of the financial indicators and ratios on profitability, growth rates, valuation and safety that give a good preliminary view of the attractiveness of the stock.


Company financial reports - Each company's website will contain the quarterly and annual financial reports that are replete with data and management comment on the company. Before buying stock, one should have read through a number of them.

Stock data websites - As well as the basic financial data in the company reports, several go much deeper in calculating a multitude of ratios and barometers of financial health of companies.

• ADVFN - most extensive free set of data and ratios around
  
• InvestorPoint - includes insider trading info
  
• Google Finance - includes data on similar companies, though the degree of similarity varies (see example below of screenshot for WJA)

Stock discussion forums and boards - Though one should always be wary of the motives and expertise of the commentary, there may be nuggets of useful information in such online sites.

• StockChase
  
• Financial Webring's forum on Stocks, Bonds, ETFs, Funds, REITs and More

Whether this method really helps zero in on stocks worth buying, we don't know for sure as Hodson doesn't offer any systematic or rigorous data to back up his claim. However, it is always interesting to experiment with and entertain a new angle to stock selection.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Borrowing to Invest: Examples of Potential Profits

In our post last week we explored the factors that contribute to success in using borrowed money to invest. Today we work out the numbers for two current possible investments that look reasonable according to our criteria.

The Calculation Tools
Many kudos go to TaxTips.ca's free Borrow to Invest Calculator that takes account of different tax rates in the various provinces (and shows how the bottom line can vary a lot across the country). We have used the calculator for our examples.

The yield to redemption on the preferred share example has been figured out using Shakespeare's yield to call calculator.

Example 1 - Leveraging a Canadian Equity ETF
Our first example uses the most popular Canadian equity ETF, the iShares S&P TSX 60 Index Fund (TSX: XIU), which features several desirable qualities:

• Diversification: This ETF holds shares of the 60 biggest companies in Canada, as determined by their market capitalization. Default risk is more or less nil, though of course there can be severe market dips of up to 40% as investors well know having passed through the 2008 crash.
• Passive Index Tracking: XIU only occasionally trades when the index itself changes. That meets our goal of trade minimization to defer paying capital gains. We note that despite its passive investing strategy, even XIU has unavoidably not been perfect in this regard in the past, as can be seen in the hefty capital gains distributions in some recent years, like 2006 (see the Distributions for XIU here).
• Canadian Equities: The Canadian-only holdings mean that dividends distributed to the investor are eligible for the enhanced dividend tax credit, another tax advantage.
• Healthy Dividend Yield: XIU's dividend yield is currently around 2.3%. This cash income to the investor will help meet a substantial part of the cash outflow for interest on the loan taken out to invest, thus lessening the potential for strain and stress on the investor.

The scenario we examine makes the following assumptions:

• Investment in Taxable Account: this is to take advantage of the deductibility of loan interest, the favourable tax treatment of capital gains and the tax credit for dividends.
• Investor Taxable Income: $60,000 or $120,000. The investor's job earnings provide the stable base to support the leveraged investing. We compare what happens with either middle income or a high income investor.
  
• Amount Borrowed: $50,000. We use the same amount for comparing the middle vs higher earning investor, though the latter could probably easily manage a bigger loan.
  
• Loan Interest Rate: 4%, based on secured loan rates commonly available now per Fiscal Agents Consumer Loans.
• Investment Time Horizon: 15 years, to allow for market swings up and down and increase the chances that the net market return over that period will be positive and reasonably close to our expected return.
• Expected Return: 6%, a total of the current 2.3% dividend rate plus capital gains to make up the rest. As we wrote about in our previous post, that seems a reasonably conservative and achievable figure given the current TSX market level.

Results:
A) TaxTips calculator screenshot below for an Ontario investor earning $60,000 of other taxable income.

• Despite loan interest payments of $2000 per year (4% of $50k) the disposable income difference after tax only requires a net cash outlay of $264 at most in year 2, which declines and becomes positive - the investor receives cash in pocket - from year nine onwards.
  
• After 15 tears, the investor is better off by a total cumulative amount of $34,665, i.e. net of the loan. That's a very nice gain, providing of course all goes according to the assumptions.

B) Summary Table By Province and Taxable Income Level

• Income level makes little difference overall within each province. The net gain is very close to the same whether income is $60,000 or $120,000.
• Provincial tax rates make a substantial difference in the net gain, almost a 20% difference between the highest / best in Quebec (over $40,000) and the lowest / worst gain in Nova Scotia ( about $34,000).

Example 2 - Leveraging a Canadian Split Share Preferred
Our second example uses Big Bank Big Oil Split Corp (TSX: BBO.PR.A) as the investment. Its features:

• Redemption Date & Exact Return: On 30 December 2016, the investor is promised the $10 redemption value, which means the current $10.25 market price will converge by that date to the $10 amount. The fixed duration of the investment allows us to compute the exact return, or yield, that our investment will achieve, using the above calculator from Shakespeare, in this case 4.58%. In addition, the investment held to maturity will produce only dividend income for tax reporting each year. There will be a small capital loss ($10.25 - $10) to report, only at maturity.
• Dividend Yield: Note that the current dividend payout is 5.12%, which exceeds the total yield due to the capital loss.
  
• Investment Grade: Backed by the value of the corresponding Split Capital shares (see our discussion of how Split Preferreds work here), which are invested in a portfolio of shares of six Canadian banks and ten oil and gas producers, DBRS rates BBO.PR.A as P2-low, which is investment grade and thus well protected against default.

Results:

• An Alberta investor with $60,000 taxable income would be $3,340 richer after 5 years. (The total gains are less in total than for Example 1 since the investment only lasts 5 years.)

• Net after tax cash flow is positive every year (we do not show the TaxTips screenshot of this result). The investment should sustain the loan on a cash basis.
  
• Provincial differences are even more pronounced, with Quebec, still at the top of the list, gaining twice (!) as much as the perennial heavy tax bottom feeder, Nova Scotia.

Caveats and Cautions:
The results depend on the assumptions. That the loan interest rate will stay at 4% is unlikely. Plugging in different numbers to the calculator, for example to see what a 5% interest rate might do to the net result, or a much smaller capital gain on XIU, could show how much leeway there is for a profitable outcome. Another variation would be to make the loan amortize, which would progressively reduce the loan and the leverage and thus the risk, over the investment horizon. An amortizing loan could enable you the investor to lock in a fixed loan interest rate. It would also indicate the cash flow required and give you an idea whether it would be supportable. Finally, to be sure of what you are doing, it may be wise to consult a professional.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Borrowing to Invest: When & How to Do It

The basic idea and attraction of borrowing money to invest is simple - if the cost of the loan is less than the return on the investment then there is a profit. You have used money you don't own to earn. That's why the operation is also called leverage - you use the borrowed money as a lever to gain a profit. However, as usual, there is a downside, since it is possible to lose money too. If things go awry, the leverage makes you lose faster, which is why there are many dark warnings e.g. What are the dangers of borrowing to invest? on the GetSmarterAboutMoney.ca site sponsored by the Ontario Securities Commission, or Wealthy Boomer Jonathan Chevreau's Financial Post column When does it pay to borrow to invest?

A few months ago, we looked at various ways to carry out leveraged investing. Today we will drill down to see under what circumstances it can work, to examine the risks, to look at tax and book-keeping implementation do's and don'ts. That should give you a better idea if borrowing to invest is worthwhile for you.

Favourable Conditions
A beneficial combination of factors specific to you and of conditions in markets and the economy will increase the chance of success.

Investor's Personal Situation:

• Able to sustain the loan payments - Whether it be an interest-only or an interest plus principal repayment, you must be able to keep up payments, otherwise you may be forced to liquidate the investments, which as bad luck could have it, might be at a time when the investments have declined in value. There should be some leeway for higher payments since some forms of loans have floating interest rates that will rise with general interest rates. In addition, when the investing is within a non-registered taxable account, there is income tax to pay each year on the investing income. Thus, the following conditions give you an advantage.
  
• Stable job with a steady reliable income,
• Little or no other debt
• Long term horizon - If you can invest the money for a longer time, such as ten years or more, and not need or expect to spend it for urgent needs, that allows you to wait out inevitable difficult market periods. Having other resources for near-term needs or wants helps a lot.
  

Markets & Economy:

• Low interest rates to borrow - This is one of the best factors in the current situation, with loans available at 4%, perhaps even a bit less. When the cost of borrowing is low, it sets a lower bar for earnings from interest, dividends or capital gains to beat in order to make a profit.
• High yields on dividend stocks - There are many solid companies paying dividends over 3%, and some even in the 4-5% range,. Against current borrowing rates that offers the promise of cash in- vs out-flow that can sustain payments on interest-only loans. Added to the benefit is that most dividends from Canadian companies are eligible for the enhanced dividend tax credit, which effectively means a very low marginal tax rate on that type of income. This improves the investor's chances of making a net profit in a non-registered taxable account.
• Reasonable stock market valuation level - The indicators we discussed in Is the Stock Market Over- or Under-Valued? suggest that US and Canadian stock markets are at a level that promise modest returns of 4 - 8% over the next ten years.

Risks & Counter-Measures
Some of the major things that could go wrong include:

• Psychological stress and panic - No one wants the anxiety of a very large debt hanging overhead when facing a large market decline that could get worse. That leads those with experience in leveraged investing to suggest: 1) only going ahead when you have at least several years of investing under your belt, which gets you mentally and emotionally familiar with the frequent falls in the market; 2) starting out with a small loan and investment; 3) buying the investments progressively so that if the market goes down after the first purchase you feel less regret (a line of credit is well suited to this tactic since you borrow as you go).
  
• Job loss - For most people, employment income is the source of cash flow that protects the ability to pay back the loan. The danger is that the layoff might occur at just the wrong time - the economy is bad, you lose your job and the markets / your investment goes south simultaneously. Opting out and repaying the loan to limit the damage may not be possible ... unless you have included that safety margin in planning as we suggested above.
• Interest rate increases - A rise in borrowing costs when the loan is on a variable rate basis may make the whole scheme unprofitable. If fixed income investments like bonds or preferred shares were bought, these would decline in value so an attempt to opt out and collapse the scheme could incur a big capital loss. There would then be a large lump sum to find to make up the total owing to the lender.
• Family home subjected to collateral call - In what could be termed a disastrous case of "collateral damage", the necessity to sell a home that had been used to guarantee a home equity loan or a mortgage might result after a big loss on an investment. Apart from the above-discussed preparations to avoid such an eventuality, before proceeding with borrowing to invest the investor should contemplate whether the potential investment gain is worth the potential pain of having to sell his/her home, alongside the probability of that event occurring.
• Investments fall in value - The most basic risk as inferred above is that the investment has lost value when you sell. The defenses against this: a long holding period for equities to ride out market slumps; a personal situation that allows you to sell only when you decide and; diversification and solid investments to avoid total default loss. (point inserted after first posting following blogger Michael James on Money's mention, which highlighted that this obvious point might not be obvious enough!)
  

Investment Candidates
First, we note that the maximum value from leveraged investing comes when the tax advantages are utilized, in particular the deductibility of interest expense and the lower tax rates on dividends and capital gains. The implication is that investing is best done within a non-registered taxable account. It also means that Canadian equity should make up the investment holdings.

Our take on the best combination at the moment includes:

• Passively managed index ETFs - The passive index management results in low turnover, which minimizes annual capital gains distributions and tax to pay. It also ensures diversification through multiple holdings, which eliminates the possibility of complete loss of capital through default and reduces the year-in-year-out volatility.
• Equity ETFs - Equity provides its return in the form of the desired dividends and capital gains. Over the long haul, equity has outperformed fixed income. We do not like some of the specialty dividend ETFs despite their enticing high distributions because often a sizable chunk of their distributions consists of Return of Capital, which causes problems with the deductibility of the loan interest (see MillionDollarJourney's Key Tax Considerations on an Investment Loan).

Some reasonable though less attractive possibilities:

• Pipeline and utility stocks - These are amongst the most stable in a business sense and as a result are so on the stock market too. All offer much better than average dividends (see our January 2011 post on these stocks)
• Split Share Preferreds - Unlike most preferred shares, this type of preferred has a redemption date and price. The price and yield you buy at today is locked in to the redemption date if you hold till then. If interest rates rise in the meantime, the market price of such shares may decline temporarily but by the redemption date the market price must converge to the redemption price. The catches are that such shares still have some default risk and that redemption dates may be within only a few years so you would need to be renewing and reinvesting the holdings with capital gains taxes to settle up earlier than desired. See our detailed post on assessing Split Preferreds.
  

Interest Deductibility Tax and Book-keeping
The general principle is that interest on the investment loan may be deducted against the investor's income (and not just investment income but against other income such employment earnings). However, the rules for carrying out the borrowing to the Canada Revenue Agency's satisfaction to ensure the deduction is not denied can be quite tricky. Consider getting the guidance of an accountant! Amongst the tricky bits:

• Investment must be capable of earning income, though it may not actually do so. If it can only ever achieve capital gains, that will not qualify.
• Book-keeping is much easier if the investments purchased with the loan are in a separate account.
• Similarly for book-keeping ease, once income is received, take that money out of the account to keep the cost basis of the debt the same as the investment.
• Watch out when withdrawing funds from the account since the amount of eligible debt may change.
  

Helpful info on these matters: TaxTips.ca's series of pages on Borrowing to Invest, MillionDollarJourney's article link mentioned above, Tim Cestnick's Borrowing to Invest article on Fiscal Agents website and his It's in your interest to know the deduction rules for borrowing in the Globe and Mail.

Next post, we will work through an example with the help of available online tools to see how the numbers work out and give a feel for how big the benefits could be.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.