Lessons for Investors from Warren Buffett's Illness

On April 17th, news reports announced that the famously rich investor Warren Buffett (see Wikipedia bio) has prostate cancer. Though it should not be a surprise that an 81 year old man who has already gone well beyond the average life expectancy should have health problems, Buffett's illness is an opportune moment to ponder a few lessons an investor could draw from the story.

The Financial Post published just such an article by financial planner Jason Heath. Heath points out the most fundamental and important lesson that Buffett has lived by all his life - spend less than you earn. The fact that Buffett is a billionaire doesn't deny the principle. It's true that he has piles of cash (or easily could have, by cashing his investments) to spend but he could fritter it away. If your income goes up but your spending rises just as fast you will be no further ahead.

Let's build on Heath's article and draw a few further lessons from Buffett's disease.

1. Disruptive health problems do happen - Illness and disease become more likely with advancing age and should not be surprising. Buffett is fortunate as he says that his cancer does not diminish his capacity to manage Berkshire Hathaway. Of course, it's not just the old that may be affected; bad health may hit at any age. We should not kid ourselves or pretend it cannot happen to us. It's wise to be prepared.
2. Have a backup person for managing investments - Some diseases like stroke or Alzheimer's may leave the investor permanently unable to carry on while others like cancer may be too debilitating during treatment. Does your husband, wife or partner know how you manage your investments and have the ability to step in? Or could a brother, sister, cousin, parent or friend do it? Perhaps a professional is a better option. The Power of Attorney (POA) is the legal document that allows the replacement person to make trades, move money etc. Contrary to what some people may believe, a spouse or child cannot automatically step in to act. The BMO Retirement Institute gives excellent pointers about the ins and outs of Power of Attorney in Financial Decision-making: Who Will Manage Your Money When You Can't?
3. Write down and file investing documents - It's good to talk to the person chosen to be the backup about your investment strategy but it's even better to write it down in a Investment Policy Statement. Prepare a list of accounts and brokers or banks that you deal with and keep the statements filed in a place they can be found. It avoids frustration and time lost looking for your backup person, not to mention possible missed actions or penalties (e.g. something forgotten in a tax filing).  For online account access, write down the access ID and password (keeping in mind that the backup person still needs to have a POA to act legally in making transactions). If the information is all on your computer, make sure the person has the password and add to the written list the filenames with critical data e.g. tracking adjusted cost base for ETFs in a taxable account.
4. Build a portfolio with some cash or equivalent holdings - Health problems may interrupt employment income and may also occasion extra expenses. Avoid adding financial worry to the health concern by having cash readily available. Various types of insurance like disability, critical illness and long term care can play a role. The investment portfolio can help as well by holding contingency funds in the form of stable short-term easily cashable investments like T-bills, money market funds, high-interest savings deposits or just cash. Tax-exempt TFSA accounts are often used to hold such funds.
5. Automate and simplify the portfolio - If your portfolio can more or less tick along on its own, there is less worry for you, less chance things will go wrong and less work for the backup person. Automation can be accomplished for those in asset building mode by telling your broker to initiate a dividend reinvestment program for any eligible ETFs (Money Smarts blog runs through broker offerings here) or stocks (Canadian Dividend Reinvestment Plans blog has a list here). For those in a retirement income-receiving mode, automation might be accomplished through selecting securities that produce income, as we previously blogged about in Generating Cash: Income from Securities with the High-Yield Couch Portfolio. Simplification is achievable by fewer holdings in a portfolio. Solid balanced portfolios can be built with a handful of ETFs - in Simple Portfolios Compared we looked at portfolios with no more than six holdings. At an extreme, a single balanced fund may do a very good job as we explained in One-Stop Investing for Your RRSP Contribution.
6. Give some of it away - Once you reach a point of having more than enough for your own needs, consider giving some of the surplus away, as Buffett to his credit has already being doing. That can be through planned giving after death, accomplished by means of a will, which everyone should have anyway. Or it can be done at any time while living, when one can derive the pleasure of seeing the donation put to use. The investor could, for example, make a Registered Education Savings Plan contribution for a family member in the next generation, allowing the money invested to grow tax-free when used for higher education. Giving securities instead of cash to a registered charity can avoid any capital gains tax as TaxTips.ca explains, as well as gaining a tax credit for the donation.

A health scare such as Buffett's prostate cancer is often a cause for a reassessment of one's goals and lifestyle. So can it also be for the investor a moment to reassess and realign investment strategy before something truly debilitating happens.

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.

Looking for Value Stocks amongst S&P 500 Deletions

The S&P 500 index is the bellwether of US stocks and it forms the basis of automatic purchase decisions for massive amounts of passive investment. Companies that get added to the S&P 500 experience a sudden price boost as all those funds holding the index create upwards purchasing pressure. But what about the companies that get deleted to make way for the new entrants since the index only contains 500 companies? Do they plummet as a result of selling pressure?

Revenge of the dumped - better returns!
Contrary to what one might expect, the deleted companies are not, on average, basket cases headed for bankruptcy and oblivion, though some are. In fact, though they do fall initially, the deletions over the 6-24 months following the index removal do much better than the additions to the S&P 500!

Huffman Funds' William Hester tells us in Misfit Stocks how the rejects from 1998 to 2004 consistently outperformed the additions each year and cumulatively up to March 2005. The stats do exclude companies like Worldcom and Enron whose bankruptcy was known at the time of deletion but they do include companies like Laidlaw, Polaroid and Bethlehem Steel that went into Chapter 11 later. The strong bounce-back of other companies overcame the pain of 100% losses on a few.

Whether its investors driving market cap too low or the S&P index maintenance committee deciding (see the Index Fact Sheet on the Standard and Poors S&P 500 webpage for how index additions and deletions work) that the company is no longer representative of the industry or the overall economy, Hester interprets the deletions as often reflecting a perception that the companies are old economy, or in a declining sector. As he notes: "Neglected and under-appreciated companies often have more life left in them most investors expect."

Life after being dumped
Perhaps it is a wake-up call to management who suffer the indignity of being excluded from the prestigious S&P 500 club that motivates improved performance for companies that are not terminally ill. Some evidence of this comes from the research paper Discretionary Deletions from the S&P 500 Index: Evidence on Forecasted and Realized Earnings by Stoyu Ivanov of San Jose State University, which found that "... actual earnings of firms discretionary removed from the S&P 500 index on average increase." Ivanov's data also covers more years - 1989 to 2007 - which enhances the idea that something consistent is going on. Nevertheless, the general caution still must be stated that the number of companies involved through the years is quite small; that sample size limits the certainty of this effect.

Maybe the better stock returns subsequent to deletion also reflects that it is easy afterwards for the company to beat much lowered investor expectations as Hester suggests.

Whatever the reason, after a stock decline before and around the deletion date, stock price recovery begins (again, this is an average and certainly not true in the case of every company) soon after deletion.

Finding and tracking recent S&P 500 deletions
Wikipedia's List of S&P 500 companies includes a table of additions and deletions going back to 2009. It's a much better source than S&P's own page linked above, which contains the official index change announcements but no convenient summary. Interestingly, the Wikipedia summary shows that most of the index deletions come about from mergers that eliminate a company as a separate entity.

There have been six non-merger caused deletions since November 2011 - Janus Capital Group (NYSE: JNS), MEMC Electronic Materials Inc (NYSE: MFR), Monster Worldwide Inc (NYSE: MWW), Tellabs Inc (NASDAQ: TLAB), AK Steel Holding Corp (NYSE: AKS) and Compuware (NASDAQ: CPWR). The Google Finance price chart of the four months since deletion shows four stocks lagging the S&P 500 (black line in the chart), one about the same and one (JNS) well ahead.


A few of the companies deleted further back in December 2010 provide more colour to the picture of what can happen to deleted companies.

• Eastman Kodak (now only listed a pinksheet under symbol EKDKQ),a classic old economy business struggling against technological change in photography, eventually filed for bankruptcy in January this year, though it still attempting to come out of Chapter 11 and continue as a viable business.
• Office Depot (NYSE: ODP) is still about 36% below its price at deletion but has risen considerably above lows at the end of 2011. The latest Q4-2011 results in February 2012 showed a company with stabilized sales and slightly revived earnings that is continuing to restructure.
• New York Times (NYSE: NYT), another old economy company, has stable or slightly declining revenues but has increased profitability recently in its latest quarterly results. In the Motley Fool stock discussion boards, investor sentiment is still said to be negative.

All three lag the overall S&P 500 by a considerable degree since deletion and investors have suffered large declines in stock price as the Google Finance chart below shows.

Investor takeaways
1) At the very least an investor in these companies will have to be patient and brave since the possibility of large losses exists.
2) Success is not guaranteed - some do well, others continue to tank. Serious analysis of the companies would be needed to determine likelihood of regained growth, recovery or even survival. (For those who may wonder, there is (as yet!?) no "Index Outcasts" ETF to provide diversification by holding all deleted companies.) Despite these limitations, index deletions can still be a useful tool for the value investor to look for potential investing candidates.

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.

Tax Champion ETFs of 2011

A year ago we sorted through Canadian ETFs to see which left the investor with the most money after deduction of taxes on distributions. Such ETFs should be of interest for an investor looking to hold ETFs in taxable account. Let's see how they stack up this year and in particular, let's find out if last year's champions still are doing a tax-efficient job.

2011 - A banner year for tax efficient ETFs
Investors will be pleased at how much they retain after tax on distributions for the 2011 tax year according to our table below. Many ETFs allow 90 cents or more to be kept from every dollar of distributions, whether the investor is in a middle or high tax bracket. Many also sport hefty distributions.



Few fallen tax angels
Most of the highly efficient ETFs of last year are still in the table. Our gold medalist the iShares (formerly Claymore) Canadian Financial Monthly Income ETF (TSX: FIE) bears a slightly higher tax burden and is now is the silver medalist group. Several ETFs that were hot on FIE's tail last year remain high up the table and have even leapfrogged FIE e.g. iShares Dow Jones Canada Select Growth Index Fund (XCG), iShares Advantaged High Yield Bond ETF (CHB) and iShares Global Monthly Advantaged Dividend ETF (CYH).

Only five ETFs from last year's stars list have become fallen angels from the tax viewpoint: BMO Equal Weight US Health Care Hedged to CAD Index ETF (ZUH), iShares Broad Emerging Market ETF (CWO), iShares US Fundamental Index ETF (C$ Hedged) (CLU), iShares US Fundamental Index ETF (Non-hedged) (CLU.C), BMO Equal Weight REITs Index ETF (ZRE). The reason is that these ETFs distributed a lot more foreign income or ordinary income.

Wide variety of sectors amongst the tax efficient
The ETFs span a wide range of equity sectors and sub-sectors, providing plenty of choice for the investor. That equity funds would deliver tax efficiency is not surprising since distributions will naturally consist of dividends and capital gains. More surprising is that bond or fixed income funds feature among the tax efficient. Clever financial engineering enables this.

ETFs designed to transform and defer tax - Advantaged funds
Many of the ETFs in our table sport the word Advantaged in their name. These funds have been specifically designed to both defer tax and to transform returns (that may in fact be based on bond income!) into capital gains. Thus, the non-taxable Return of Capital cash distributions received are in fact deferred capital gains, which gets taxed upon sale of the investment. It is all perfectly legal, though complicated - see Canadian Couch Potato's explanation. The Advantaged funds will very likely continue to be highly tax efficient.

Tax efficiency another way - no distributions at all
The ETFs in our table all made taxable distributions but BetaPro offers a handful of ETFs that make no annual distributions and only expose the investor to capital gains deferred till eventual sale of the holding. Such ETFs would be right at the top of the tax efficiency. The ETFs are the Horizons S&P/TSX 60TM Index ETF (HXT) and the Horizons S&P 500 Index (C$ Hedged) ETF (HXS). Canadian Couch Potato did a good job analyzing how they work here.

Searching out tax efficient funds
We have compiled our table manually using the annual tax breakdown of distributions from iShares, from BMO and from Claymore (for all the funds whose trading symbol begins with "C" and FIE; Claymore recently sold their ETF business and future breakdowns will be issued by the new owner iShares). The tax character of prior year distributions going back to fund inception are found on each ETF provider's website under the Distributions tab for each ETF. A consistent past record of tax efficient distributions helps indicate what the future will be like.

A handy way to find the most efficient ETFs considering all types of distribution strategy is the TMX Money ETF Screener. The screener allows narrowing choices by asset class, region or sector amongst other variables.

As we remarked in last year's post, other important factors also come into play when assessing and deciding upon which ETF to buy: portfolio fit within a targeted asset allocation, fees and risks or potential return. It is however, very useful to know and consider the past likely future tax consequences of holding different ETFs in taxable accounts.

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.

Comparing Tax Characteristics of US Equity ETFs

In our last post we examined how to calculate Canadian income taxes for one US large cap equity ETF. Today, we compare its tax characteristics with those of four other popular ETFs in the same category and find some dramatic and significant differences.

The US Large Cap Equity ETFs - Our five ETFs all hold US Large Cap Equities. Four are traded on the TSX in Canada and one is traded in the USA:

• BMO US Equity Hedged to CAD Index ETF (TSX: ZUE)
• iShares US Fundamental Index Fund (also C$ hedged; formerly under the Claymore brand) (TSX: CLU)
• Horizons S&P 500 Index (C$ Hedged) ETF (TSX: HXS)
• iShares S&P 500 Index Fund (CAD-Hedged) (TSX: XSP)
• iShares S&P 500 Index Fund (not hedged; traded in USA on NYSE: IVV)

The ETFs display large differences in tax types of income - A quick look at the table below showing the 2011 breakdown of distributions by the five ETFs reveals a large variation in the taxable types of income. This is despite all ETFs having the same investment objective to track US large cap equity and four out of five being similar in doing currency hedging.

Three patterns of taxable income -

1) Foreign income only - The US-traded IVV distributed only foreign income in 2011. In fact IVV will only ever distribute foreign income to a Canadian investor since dividends from US companies do not receive the lower rate of dividends from Canadian companies. Foreign income is taxed at the highest marginal rate, the same rate as interest. IVV never distributes capital gains (see its historical distributions here).

2) Good deferred capital gains only - Horizon's HXS has distributed no taxable income at all in 2011 and should not normally ever do so due to its construction as a total return swap. The dividends from the underlying S&P 500 index are never actually explicitly received, instead being implicitly and automatically received and reinvested, so a holder of HXS only is liable to tax upon sale of his/her HXS holding. Since there are no distributions, only capital gains tax applies at the time of eventual sale. The tax-deferred reinvested compounding of dividends is a big plus for HXS, which is especially advantageous in a taxable account where taxes normally apply every year. The higher the S&P 500 dividend yield the greater the benefit for HXS holders. HXS' transformation of US dividends from high tax rate foreign income into deferred lower tax rate capital gains is legitimate and accepted by Canadian tax authorities. The Horizons HXS webpage explains the swap and the tax advantages in more detail.

3) Bad immediate capital gains plus foreign income - BMO's ZUE has a big element of capital gains in 2011 while none of the others do. However, the two funds with a longer track record, CLU and XSP, both have had several years of large capital gains attributed and distributed to shareholders for tax reporting as seen in the table below. In 2010, XSP had a large distributable capital gain resulting from its currency hedging activities as the iShares 2010 distributions press release noted. ZUE and CLU are subject to the same capital gains exposure from hedging.

This type of capital gain is not cash received by the investor but is reinvested in the ETF. In a taxable account, that would create a large capital gains tax liability in the years when they occur. An attributed immediate taxable capital gain is bad because the taxation is immediate but the investor only gets the benefit later on when the ETF is sold and the capital gain at that time is less by virtue of the higher Adjusted Cost Base. In effect the capital gain has been brought forward for taxation but the investor only receives it later on.

The sporadic recurrence of large capital gains reinforces the importance of updating the Adjusted Cost Base (ACB) for CLU, XSP and ZUE held in a taxable account. If the reinvested capital gains net of return of capital (shown in the blue text cells in the above table) are not added to ACB the investor ends up paying tax twice - once in the year of receipt on the T3 slip and again in the year of the holding's sale through a too-low ACB (since declarable gain = sale amount - ACB).

Foreign tax paid hurts XSP, CLU and ZUE in tax-deferred accounts - The red highlighted cells in the bottom part of the first table above indicates where the tax deducted in the USA by US authorities is irretrievably lost to Canadian investors. The foreign tax is neither avoidable nor claimable as a tax credit or partial payment against Canadian income tax owing. By contrast the US-traded ETF IVV, when held in an RRSP or other recognized retirement account, such as a LIRA, LIF, LRIF does not have any foreign withholding tax levied against it. IVV holdings in a TFSA or RESP do not escape the foreign tax levy since the US government does not recognize these as retirement accounts. HXS avoids US foreign tax altogether by virtue of its construction using a swap.

Taxes are important but not the only point of comparison amongst ETFs - Other fees and costs, currency hedging effects and risk factors also come into play over and above the tax angle when deciding which ETF is best. For instance we took an in-depth look at XSP and HXS side by side in which the final answer was not categorical. We also explored the pros and cons of investing through Canadian-traded vs US-traded ETFs for identical asset classes where we found a raft of factors in addition to taxes to consider.

Bottom line:

• HXS wins the prize for best tax characteristics - it works extremely well in any type of account and only generates lower tax rate deferred capital gains and no highest tax rate foreign income in taxable accounts
• IVV is best held in a retirement account where it works just as well as HXS and much better than XSP, CLU and ZUE. It is not good to hold IVV in a TFSA or RESP. In a taxable account there is at least a tax credit to offset Canadian income tax against the annual distribution.
• CLU, ZUE and XSP do not find an ideal resting place in any type account. The deferral of taxes in registered accounts gives that location an edge despite unrecoverable unavoidable loss of the foreign withholding tax paid.

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.