Return of Capital - Examples of Good and Bad among ETFs

Return of Capital (ROC) can be a thorny problem for investors seeking the highest after-tax income in a taxable account, though it can be a serious negative in tax-sheltered accounts too if it means the ETF is simply giving you your money back (that's bad ROC). Some ETFs deliberately distribute ROC-type cash, which in some cases is good and other cases is bad. For a taxable investor, good ROC helps because such a distribution of an ETF's return is not immediately taxable. Instead, the ROC is received tax-free, to be taxed only later as a capital gain when the investment is sold. Bad ROC for the taxable investor is a non-event - why should anyone be happy about getting their own money back?

The principles of good vs bad ROC
We had previously outlined the nature and the source of good vs bad ROC in this post. Morningstar.com also has an excellent explanation of ROC in a three part series of slides on this page. A third worthwhile rundown is offered by The Wealth Steward blogger Dan Hallett writing about mutual funds, though the same principles apply to ETFs, in T Series Funds: The Tax Efficiency Myth and Structural Risk.

Calculating after-tax efficiency and yield of ETF distributions for 2012
To find the ETFs which might attract an income investor with high payouts, amongst which we are also more likely find examples of bad ROC, we used the ETF screener at BMO InvestorLine (see our previous post ETF Screeners Compared for other options). to pick the ETFs with the highest dividend/distribution yield.

We then carried out the laborious manual work whose results are shown in the comparison table below. Mostly we used the websites of the various ETF providers who provide the raw breakdowns of distributions and their tax types (ROC, capital gains, reinvested capital gains, dividends, other income i.e. interest and foreign income) and the Net Asset Value (NAV) price history. Tax rates for these types of income came from TaxTips.ca. We used Ontario rates for a middle and a high bracket taxpayer. Though the exact amounts will vary by province, the pattern will be the same - higher brackets pay more overall and the advantage of dividends over capital gains in the middle bracket reverses for the higher bracket.

The idea was to figure out:
1) which ETFs produced the most tax efficient income - how much of each dollar of distributions ended up in the investor's wallet after-tax - and,
2) which ETFs produced the most after-tax yield / return i.e. the tax efficiency combined with the varying cash distributions.

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ETF distributions for 2012 - which ETFs were good and which bad?
It is perhaps little surprise that several of the most efficient and highest yielding ETFs suffer considerably from bad ROC. Horizons' funds with symbols HEX and HEF, First Asset's LXF and BMO Financial's ZWU all simply gave back investors some of their own capital. When the NAV of the ETF at the end of the year is lower than it was at the beginning, the amount of the reduction is simply giving back capital. The high cash distribution was only partly made up of real income or gains from the fund's holdings.

There were however, a number of funds that distributed very attractive after-tax cash yields at double or more that of ETFs tracking the main equity indices. Some included nothing but ROC - iShares' CHB, CSD and CVD and Horizons' HAF. That's good ROC. In fact, these ETFs have been designed to create only immediate capital gains or ROC for deferred capital gains (see our last post which examined another ETF of the same type the iShares CAB for links to how these ETFs work). Alas, these ETFs seem to have worked too well, the federal government has taken note and the March 21st budget announced the intention (see Investment Executive article) to close down the tax loophole that can transform high-taxed interest into deferred capital gains taxed at half the rate. In the case of one fund we have marked as being threatened in the table above - Horizons' HXT - the ETF provider believes that fund will escape the budget restriction since it makes no distributions. Of course, there is no law yet so we investors will need to take note when the federal government passes the relevant law and regulations to see exactly what is ultimately affected, including possibly HXT.

Another lesson from our table is that a number of ETFs with no- or low-ROC still gave off high after-tax yields, though their tax efficiency was less e.g. iShares' FIE and CDZ and BMO's ZHY.

Of course, our results are for 2012 only. An important question for the investor is whether the future will be like the past. How sustainable are the distributions of the high-yielders? We'll take a look in our next post.

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.

GIC vs Tax-Advantaged Bond ETF - Which is best in a taxable account?

Situation: You have maxed out your RRSP and TFSA accounts and you want to put some fixed income in a taxable account, perhaps because your total portfolio asset allocation calls for it, or you simply want to receive the income to spend. Let's compare two options to do it, the well-known GIC against a specialized ETF oriented to this situation offering tax advantages.

1) Guaranteed Investment Certificate (GIC)

• Safety: ultra-safe, all maturities up to five years backed by federal or provincial deposit insurance
• Current rates: up to 3.15% with 2.3% readily available for a five year maturity (at BMO Investorline, we found a max of 2.45%) - see a comparison table at the Globe and Mail
• Taxation: taxed every year at the Other Income rate, the highest marginal rate, whether the interest is received in cash or paid out only at maturity - see tables of personal tax rates by province at TaxTips.ca

 2) iShares Advantaged Canadian Bond Index Fund (TSX symbol: CAB)

• Safety: relatively safe with respect to default but its complicated structure and its holdings expose it to various other risk factors, in particular interest rate risk and tracking risk, and to a lesser extent credit risk and counterparty credit risk. Interest rate risk exposes the investor to a drop in the price of CAB's units if interest rates rise. Tracking risk is higher in part because the forward contract sees TD Global Finance, the counterparty, promise only the return of an bond portfolio, net of expenses, that attempts to mimic the index. Since the DLUX Bond Index holds hundreds of different bonds and requires daily rebalancing, it is not a surprise that CAB doesn't mimic the index perfectly while incurring extra costs. Credit risk of the bond holdings is CAB's problem should it arise, though that risk is fairly low as all the holdings are of investment grade.
• Current rate: yield to maturity (YTM) of CAB is 2.14% per the iShares website but that is a gross rate subject to reduction for a management expense ratio cost of 0.33% plus other fees, especially the forward contract fee of between 0.55% and 0.75%. On top of those costs are inefficiencies and return drags that show up as extra tracking error, aka difference of performance, with CAB's target index. The estimated current yield must therefore be adjusted to about 1.2% (=2.14 - 0.33 - 0.6). Note that neither the average coupon rate for the bond holdings (3.67% per the webpage), nor the cash payout distribution yield (2.73%) is the correct rate to use in comparing the value/return of CAB against the GIC option as we explained in Fixed Income: Which is "best" - GIC, Individual Bonds, Target Maturity ETF or Traditional ETF?
• Taxation: taxed at the Capital Gains rate, which is half the rate for Other Income, despite CAB being a bond fund. Most years, cash distributions are paid out as Return of Capital (ROC), which isn't taxed at all when received, and is taxed later. This is the source of the attraction of CAB - lower tax rate plus deferral of tax.

CAB is quite complicated and its workings are well explained in a fine series of posts by Canadian Couch Potato in which he explains the structure that utilizes a forward contract, the costs and risks and how the cash payout mechanics work.

GICs offer a better return than CAB at the moment
Our comparison, based on a five year investment, shows that despite the tax advantages, the yield on CAB is too low, by almost 0.5%, to beat out GICs. The main reason is the more or less fixed costs of MER and forward fees. As our table below shows, CAB would need to yield at least 1.65% to equal GICs paying 2.45% annually. That is even assuming that taxes on CAB's returns were deferred till the end of the five years. As the Distributions tab on the iShares website shows, indefinite deferral has not been the case throughout CAB's short life since 2009 startup - its distributions in 2010 were not ROC but capital gains. The fact that a strong equity market can trigger the shift from ROC (an explanation related in Couch Potato's payout mechanics post) tells us to expect occasional future episodes of the same. (It is an interesting thing to note that BlackRock has an incentive to pick the worst stocks for the equity portfolio so that it will have no capital gains and only return of capital!) Thus CAB would need to pay out an even higher rate to compensate for taxes to be paid sooner.

If interest rates start to rise, CAB will become more competitive
The corollary of CAB's fixed costs is that as interest rates go up and CAB's yield rises, GIC s will need to provide a much bigger interest rate spread to keep ahead. We have illustrated this in the lower part of the table where GICs would need to offer 4.58% to breakeven with a net 3.0% yield in CAB. The higher interest rates rise, the more the effect of the tax rate difference. The higher your tax bracket and the higher the tax rates of your province, the greater the effect as well. To figure out the breakeven point, the above table can be used substituting the relevant current numbers.

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.

New Improved Model Portfolio: The Smart Beta

Last week's post on the Swensen Seven model portfolio described a classic passive index ETF approach to building and managing a portfolio for long-term investing. It is an approach that uses ETFs whose holdings are selected and weighted by market capitalisation, for example the iShares S&P/TSX 60 Index Fund (symbol: XIU) that comprises the 60 largest capitalisation companies on Canada's TSX stock exchange.

This week we present an alternative approach based on the evolution of modern financial research. Two themes are of special interest for the individual investor.

1) Smart Beta - The research over the years has revealed that though the market index is necessary as the benchmark against which to compare results, it is not the best investing strategy. There are better strategies, and ETFs that use such strategies, to achieve enhanced returns with the same risk, or the same returns with lower risk. Such strategies are often called Smart Beta because they offer broad exposure to the market - the term Beta represents the sensitivity of a stock to the overall market - while intelligently taking advantage of anomalies that can boost returns. (A good source for much of the highly technical research is the EDHEC Risk Institute whose papers are replete with references to all the academic and industry research)

2) Allocation and Rebalancing to Equalize Risk - In addition, research tells us that traditional fixed target allocations, such as those in the Swensen portfolio, do not actually represent the true riskiness of the portfolio. Equity typically has a much greater volatility than fixed income, which means its influence on overall portfolio volatility is much greater than is apparent in its asset weight. By explicitly taking that into account, both at the time of initial assembly of the portfolio and when rebalancing, we can further boost the return vs risk performance of a portfolio. (A thorough, though again highly technical source, is a brand new book by Jacques Lussier, Successful Investing is a Process)

The Smart Beta Portfolio
Smart Beta is exactly the same as the Swensen in terms of asset classes. The main differences between the Smart Beta portfolio below and the Swensen are: 1) most of the ETFs are different; 2) the weightings are changed.

The ETFs
We note that the combined annual expense ratios of the portfolio are about double that of the Swensen - 0.33% vs 0.17%. That is a performance drag that the Smart Beta must overcome in order to be worthwhile, though the research on historical back-tested results indicates it should do so easily.

Principles underlying the portfolio

• Selection of efficient ETFs - Efficiency means a better risk vs return trade-off than the equivalent cap-weight ETF. The ETFs chosen exploit one or more of the acknowledged stock market anomalies (aka risk factors) - small cap stocks outperform large caps, value stocks (low Price to Book Value or Price to Earnings) outperform growth stocks, momentum stocks outperform in the short term, and lower volatility stocks outperform highest volatility stocks. 
• Variety of efficient ETFs - Efficient ETFs come in different flavours with one type emphasizing the Small cap factor, e.g. an ETF with Equal Weight on each stock, or Value e.g. an ETF that uses Fundamental accounting factors to select and weight stocks, or selection by Low volatility (aka low beta). In different time periods, one or other factor under- or outperforms, so we have chosen a mix across the flavours as shown in the chart above. That is the reason we have included two different ETFs, one a Fundamental index (PowerShares FTSE RAFI Canadian Fundamental Index, symbol: PXC) and the other a Low Volatility (BMO Low Volatility Canadian Equity ETF, symbol: ZLB) for the single largest asset class, Canadian equity.
• Risk-balanced for economic environments and stock market conditions - The asset classes match up with those in the four quadrants of economic environments (economic growth or recession across inflation environments of falling or rising inflation- see chart below reproduced from Bridgewater Associates' The All Weather Strategy). Some of the asset classes in the chart are not available to individual investors, so we have boosted the allocation to bonds to bring the risk balance more into line. The variety of ETFs are chosen to respond to the different stock market conditions.
• 
• Risk-balanced for volatility and correlation - As we noted above, equities are almost always more volatile, i.e. riskier, than fixed income. This is reflected in the 12 month trailing standard deviation for the various ETFs shown in the table of ETFs. We have thus boosted the allocation to the bond ETFs to bring greater balance for the amount of volatility risk each asset class contributes to the portfolio. Another reason to increase the bond allocation is that bonds have the extremely desirable property of being un- or negatively correlated with equities, a property that boosts returns over time through the portfolio rebalancing bonus (see our previous rebalancing post).

Rebalancing is critical
The Lussier book examines in great detail various methods of rebalancing as a return enhancing activity. It concludes that the best method of all is to rebalance to keep constant the overall portfolio volatility. Unfortunately that depends on the movement of the combination of market price volatility and of correlation between assets, the data for which is normally available only to institutional investors. Therefore, we propose the following method for rebalancing, which almost all the time works better than the standard annual rebalancing we proposed in the Swensen: when the major asset class groupings - total equity and total fixed income - deviate more than one quarter (20%) from their assigned weight i.e. the total of fixed income is 40%, so anything below 32% or above 48%, rebalance back to initial weights in all the asset classes.

Set your expectations properly - Smart Beta works on average over many years. Outperformance is not automatic and guaranteed to happen every year. There can be, and have been, lengthy periods of multiple years in the past, such as during the 1990s, when the standard cap-weight approach does better. This would normally be during periods of strong upward equity movements, such as the 1990s tech bubble. Nothing captures market exuberance like cap-weight! On the other hand, the Smart Beta should experience much less extreme downsides, since it will also avoid sky-is-falling fear. We all need to set our expectations appropriately since failing to do so will likely mean bailing out prematurely.

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.

A Model Pre-Retirement Portfolio for Canadians - The Swensen Seven

David Swensen is justly famous as an investor for leading the fantastic multi-decade long term success of the Yale University endowment fund. If anyone is worth listening to, it's him. Fortunately for us ordinary investors, Swensen has also put his thoughts on paper, in the form of the 2005 book Unconventional Success. In the book, he tells us what to do and what to avoid based on his experience and insider knowledge. The advice is specific enough to translate into an actual investment strategy, though he stops short of identifying the actual mutual funds or ETFs required. Paul Farrell has done that on MarketWatch for the US investor and it shows some impressive returns over the past ten years. No one seems to have adapted Swensen's ideas for the Canadian investor, so let's give it a go.

The Portfolio
Swensen lists only six asset classes but we have sub-divided foreign equity into USA and the rest of the developed world economies (Europe, Asia, Far East - EAFE) in order to find convenient and low-Management Expense Ratio (MER) ETFs.

An investor with $20,000 to invest in total would thus buy 30% x $20k or $6,000 of any one of four low cost broad market ETFs - HXT, VCE, XIU or ZCN - that will produce more or less equivalent performance (see our previous post comparing these ETFs). Note that the portfolio share is in Canadian dollars. We would need to calculate the US dollar exchange to know how much to buy of the US dollar-traded ETFs VTI, VEA and VWO.

Note that in the real return bonds class, it is quite possible, once you have $5,000 (the typical minimum for a bond purchase at discount brokers) or more to allocate to that class, to buy individual bonds. The Canada maturities are staggered in 5 year maturity increments (see Finiki.org for details). Six bonds build a complete ladder with maturities from 2012 to 2044.

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The ETFs
Below are details of the ETFs and their respective MERs along with the average portfolio MER weighted by the share of the total portfolio, an outstandingly low MER of 0.18% per year. Low costs are key to the investor retaining as much as possible of the long term market returns.

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The Principles behind the portfolio
Readers will have to get hold of the book to get the complete explanation, which is well worth doing as Swensen writes in readable common sense language, but here are some key drivers for the portfolio:

Asset classes must meet certain criteria

• Basic, valuable, differentiable characteristics - substantial expected returns, rising with inflation, protection against financial crises
• Return based on the market, not active management, not market timing, not security selection, which is why all the ETFs above are broad market and cap-weighted
• Wide, deep investable markets to ensure long term liquidity and low cost investment action

Asset classes each have a role - Each asset class, he explains, has a specific function in the portfolio, complementary to the others. That accounts for some notable departures from what many others consider to be a standard basic portfolio, such as the rejection of corporate bonds altogether to hold only the safest government bonds. As our table of the role of each asset class below notes, the bonds are there for protection against financial catastrophes and thus need to be of the highest possible credit safety i.e. government bonds. It is interesting to note that Swensen wrote his book in 2005 before the credit crisis crash, during which government bonds did exactly what he said they would. We have substituted bonds of the Canadian federal government for Swensen's US Treasury Bonds to reflect our Canadian investor perspective. Besides, these days Canada has a Triple AAA credit rating, better than that of the USA.

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No asset class dominates and all are large enough to influence overall results
Note that in total the growth equity portions add up to 50% as do the protective fixed income and real estate classes. Similarly, there is a hefty total of inflation-protection assets and financial crisis protection assets. Foreign equities also provide valuable diversification through exposure to currency. Within limits, rather than being an unwanted risk to be removed by hedging, currency exposure is useful, which is why we have avoided all hedged ETFs. Swensen says this and we have noted currency benefits too e.g. A Falling Canadian Dollar Can be an Investor's Friend and The Historical Effect of Currency and Inflation on a Canadian Investor's International Portfolio.

Pre-retirement savings phase means long term orientation - That in turn pushes the portfolio as follows:

• Substantial equity holdings since there are decades ahead to wait through market bubbles and crashes, recessions, wars, spendthrift governments etc and since equity is what will provide the growth
• Long dated federal bond fund (ZFL has an average bond term of 21 years and a duration of 14 years) instead of a short- or mid-duration fund. Despite the high likelihood that interest rates will certainly rise and hurt bond prices when then do, that is not a problem for the investor whose time horizon (time to remain invested before spending the money) is as long as the duration as we explained in this post on interest rates and bond ETFs.

Income tax-minimization dictates preference for RRSP and TFSA and the account placement of certain ETFs 

• Tax-deferred (RRSP) and tax-exempt (TFSA) accounts are the first choice for all investments over a taxable account, as we explained in this post; the choice between RRSP and TFSA depends on a number of factors related to the investor's income, which we examined in this post
• Bonds should go in tax-preferred accounts (this post says why)
• Foreign equity ETFs should not go into a TFSA due to withholding taxes as we wrote about here

Rebalancing
Every day markets rise and fall and the different asset classes will rise or fall out of sync with each other. Swensen emphasizes the importance of buying or selling portions of holdings to keep the asset classes at the intended target allocations. While the enormous Yale endowment fund has the time and resources to do this daily apparently, he does not recommend a specific strategy for the individual investor, so here we have had to fill in.

Rebalancing rule - The rule we are proposing is a trade-off between trading costs, investor time and effort and maintaining the risk balance, which is the main aim of rebalancing. First, new money contributed to the account should go to the asset class furthest from its target. Second, an annual review and rebalance date should be set to make a set of trades to rebalance. We have written more on this topic in Portfolio Rebalancing - What, Why and How.

Seven is supposed to be a lucky number but the Swensen Seven portfolio is designed to be better than random and put the odds of luck on your side through a well thought out structure from a highly successful investor.

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.