Monday, 21 April 2014

The Permanent Portfolio: Pros and Cons for Canadian Savers and Retirees

Harry Browne's Permanent Portfolio (PP) idea, as explained in his book Fail-Safe Investing: Lifelong Financial Security in 30 Minutes, has been around for over three decades. Though he passed away in 2006 his ideas still influence many investors. It is a portfolio strategy with much appeal.

First, it has achieved excellent returns, a 9.6% annual before-inflation compound growth rate with very few years of losses, and fairly small losses at that, according to stats on present-day acolyte Craig Rowlands' Crawling Road blog.

Second, PP is dead simple to implement and maintain quite cheaply with ETFs - only four holdings - cash (government T-Bills or money market funds), long term federal government bonds, domestic equities and physical gold - that need rebalancing trades once a year back to an equal 25% allocation.

Third, it is based on an intuitive logic, that it's goal is to withstand the four major economic conditions - prosperity, recession, inflation and deflation by the choice of the four asset types which counterbalance and complement each other by having at least one do well while other(s) do poorly. It's a similar idea to the possible range of economic conditions driving the portfolio structure we described last year in New Improved Model Portfolio: the Smart Beta. Though growth of the portfolio is an objective, even more important is the goal to preserve wealth.

This latter idea of protecting against the downside makes the strategy, if it works, especially appealing to retirees who do not want their withdrawals during negative market events or economic phases to irreversibly wipe out capital. We'll examine the PP both for a retiree withdrawing some money every year and for a person in the savings accumulation phase of life, i.e. not withdrawing any money.

Testing required - Is Canada the same?
But the USA is not Canada, things might not work the same, especially since the US dollar is a safe haven currency. When the the 2008 crisis hit, the Canadian dollar got hammered. Did that matter? Would a Canadian have achieved lower volatility and a minimum of mild down years?

For an approximate answer, we turned to a favorite free tool, Stingy Investor's Asset Mixer. We can get roughly the asset classes for a Canadian version, i.e. using Canadian investments, of the Permanent Portfolio. We can even apply MER-like fees, in the form of negative "alpha" in the tool, at ETF levels in this test, to make results more realistic. The data goes back 44 years to 1970 and forward to 2013, so we get coverage through the nastiness of the high inflation 1970s, many recessions and growth periods, and various market crises, including the latest one, the 2008 financial crisis. The main misalignment is that the Asset Mixer uses an index of corporate plus government bonds, whereas the PP includes only government bonds. This matters when, for instance, the financial crisis hit in 2008 and government bonds held up while corporate bonds plunged. We compared results to an ultra-simple conservative Benchmark portfolio - 60% Long Canadian bonds and 40% TSX Composite Index Canadian equity.

Results
Scenario: Retired investor withdrawing 4.5% per year on a $100,000 starting value in 1970 (screenshots of Asset Mixer output below)

  • PP ends up after 44 years of retirement with exactly the same amount in real after-inflation pre-tax terms as it started out with (we cheated a bit, just plugging in different withdrawal percentages till we came up with 4.5% as the figure that would leave us even). Pretty darn good, since most of us won't be lucky enough to live 44 years of retirement!
  • Benchmark portfolio survives just as well, in fact ending with a bit more than the starting value - almost $114,000.
  • PP is a lot less scary along the way. It's on-going year-by-year portfolio value always hovered around the $100k mark, its lowest balance being about $94,000 in 1976 and 1992. The worst single year drop was 21% in 1981. Compare that to Benchmark. It's worst single year was 1974's 27% drop. But Benchmark kept falling, unlike PP, and declined to $53,000 by 1981! Imagine the panic and worry sitting there in early/mid retirement looking at that kind of red ink on your account statement, not able to know that things would bounce back. PP had more down years than Benchmark, 24 vs 18 (more than half of total years too!), yet surely they would not have hurt as much as the sustained losing skid of Benchmark during the 1970s.
(click to enlarge images)
Permanent Portfolio Year-by Year

PP Stats

Benchmark Year-by-Year

Benchmark Stats


Scenario: Younger investor in savings mode - no withdrawals on initial $100k investment
  • PP ends up with considerably less end value than Benchmark - only $766,000 vs $991,000, a 23% difference. The avoidance of withdrawing money early on allows Benchmark to power ahead later on. The big question for the investor is thus whether it is worth enduring the greater volatility and the longer lagging periods for the much better long run result. The bad period of the 1970s isn't nearly so bad as for the retiree. The most extreme dip is down to $89,000 in 1974 and 1981 is the last year the portfolio fell below starting value. The PP on the other hand never falls below starting value and experiences fewer (9 vs 11), less severe (-17% vs -23%)  down years.
  • Results quite similar to the USA - In nominal pre-inflation terms, which seems to be what the Craig Rowland link above shows, the Canadian PP had only three down years (same as US PP and two of them the same years, 1981 and 2008), a very mild worst drop year in the same year (1981) of 7% (vs 4%) and a compound growth rate of 9.1% (vs 9.6%). It is also interesting that PP in other countries seems to have worked to, as this post shows for the UK, Japan, the Eurozone and even Iceland for different time periods. 
PP Nominal Stats


ETFs to implement a Canadian Permanent Portfolio
Here is the lowest MER cost way to implement a PP in Canada:
Bottom Line: Almost surely, the PP will make investors, including this blogger, uncomfortable since it is a marked departure, especially with the high weighting to volatile gold, from mainstream finance and most standard portfolio allocations to the various asset classes. It seems to have worked and its logic in holding assets that respond to different economic environments, makes intuitive sense. There is still the question as to whether it will continue to work in future - is the limited number of assets sufficient to deal with all potential future circumstances, particularly new types of crises? It's hard to say yes, and switch wholesale to such a portfolio model. Yet it's hard to say no too, given the results, especially for a retired investor. We're intrigued but sitting on the fence on PP.

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.

Friday, 11 April 2014

Light at the end of the ACB Tracking Tunnel for ETFs?

One of the few thorns in the side of investors holding ETFs in taxable accounts has been the necessity to track their Adjusted Cost Base (ACB) in order to correctly calculate capital gains for income tax reporting. The T3 and T5 slips received from brokers enable the reporting of yearly income without any problem but figuring out capital gains after a sale of ETF units can be a complicated headache, as our posts explaining how to do it here and here would suggest.

Note that such issues do not arise at all in any kind of registered account so anyone with ETFs only in such accounts can relax. There's no tax reporting or ACB tracking to do.

Return of Capital (ROC) and Re-Invested (Non-cash) Distributions (RID)  - Complexity that matters
The challenge of figuring out the correct ACB in a taxable account arises from the requirement to subtract the amount of any ROC and to add any RID from the starting ACB.

ROC - The ROC has always been fairly easy to find as it shows up on T3 slips in box 42 for Canadian-listed ETFs. (US-listed ETFs don't have the problem of ROC and RID as Canadian Couch Potato explains in Adjusted Cost Base with US-Listed ETFs). Box 42 shows the actual dollar amount to subtract from ACB. Fairly simple.

RID on the other hand has required several extra steps. First was finding a source for data. The various ETF providers such as iShares, BMO, Powershares, RBC etc almost all do so in one manner or another somewhere on their website (usually the Distributions tab on an individual ETF's profile page).

The better comprehensive source is CDS Innovations (kudos to Canadian Couch Potato for noting this site, which is not well enough publicized) where the ETF providers are legally required to upload the data for all their ETFs within 60 days of year end. You need to have Excel to open the files (free software such as OpenOffice unfortunately does not work). Each ETF has a file for each year. A screenshot of part of the 2013 list with some BMO ETFs is below.
(click image to enlarge)

The second step is to actually do the calculations. That involves taking the per unit/share amount and multiplying by the number of ETF units/shares held at the RID distribution date, which is usually, but not always, bundled with the regular cash distribution in the last distribution of the year in late December. If you do not sell the units before the indicated Ex-dividend date (see explanation in the Globe and Mail of the various types of dates relating to dividends) then you can add the RID amount to your ACB. That's important for the investor since a higher ACB means less of a capital gain (Sale price minus ACB = Capital Gain) to report upon sale of the units. As we noted in our previous posts on ACB, the RID amount is taxed in the year that it is allocated, so to avoid double taxation when the units are sold, it is necessary to add the RID to ACB.

Example: How important RID is can be seen in an example. Take a popular ETF, the iShares S&P/TSX Capped Composite ETF (TSX symbol XIC) which conveniently does show a complete distributions history on one page. Suppose an investor had bought 1000 units on March 1, 2001 at the closing price that day of  $9.84 and sold on December 30th, 2013 at the closing price of $21.33 (historical prices here on Yahoo Finance). The sum of Re-invested distributions in that period is $1.96422 and represents 17.1% of that gain. At a 40% marginal tax rate, forgetting to add in the RID would mean paying an extra $393 in income tax (1000 units x $1.96422 x 50% capital gains inclusion x 40% marginal tax rate = $393). Of course, the summed ROC of $0.31571 would need to be subtracted to properly peg the ACB. But the net of RID and ROC would still mean a saving of about $330 on a capital gain tax bill of $2300 had no adjustment for RID and ROC been done.

This example illustrates another reality. Over time the amount of Re-Invested Dividends given off by ETFs vastly outweighs ROC, so it is even more important not to forget it. The government certainly doesn't want you to forget subtracting ROC from the ACB, since that increases the capital gain and therefore tax, but it certainly won't mind or care if you forget adding the double-tax eliminating RID!

Online brokers to the rescue with automatic ACB updating
A solution that seems to work in most circumstances at most brokers is simply to use the Book Value tracked and updated automatically by the online broker. Brokers update the ETF Book Values for both ROC and RID data. Below is a sample entry in a broker account for RID distributed to a shareholding of 2200 shares of the BMO Low Volatility Canadian Equity ETF (ZLB) owned at the end of December 2013.
(click to enlarge)

The offsetting positive and negative dividend transactions of $692.96 serve to increase the Book Value but leave no extra cash in the account, since RID is a non-cash item. This type of book-keeping helps explain why RID is sometimes called a phantom or special distribution. We can check that the amount is correct by going to BMO's webpage for the ETF where the Distributions tab shows a RID amount of $0.312144, which when multiplied by 2220 shares equals $692.96.

A similar annual entry would update Book Value with the same amount that appears in the T3 box 42 total year ROC and would reduce Book Value.

That's the good news, now the caveats. The accuracy of automatically updated Book Value aka ACB will not be reliable in certain circumstances:
  • Distributions made in years before the date such automatic updating started; at one broker it was 2005, but check with your own.
  • ETFs transferred, especially partial transfers, between online brokers - the Book Value may not follow; it is possible at some brokers to manually adjust the Book Value yourself online or phone the broker to request it be done to the correct figure you have calculated. After that, it should update correctly.
  • The same ETF held in multiple brokerages - each broker keeps its own Book Value correctly but you must, according to the Canada Revenue Agency, sum and average all your shares for ACB. If you sell from one of the accounts, the proper ACB per unit is the average of all units, not the Book Value per unit of the units in that particular account.
  • Delay between the time the RID or ROC was distributed and when the adjusting transaction shows up in the account - as we see with the ZLB example above, it took two months from January to March for the RID to show up and the ROC has still not done so; yet this is not a big impediment since any sale in January this year would not need to be reported for income tax until next year's return.
  • Mistakes can happen and some brokers may be more diligent or careful than others updating RID and ROC, as some comments in this Couch Potato post suggest. Spot checking transactions for ETF on statements for March and April when RID and ROC adjustments should show up is a good idea. The brokers disclaim any legal responsibility for the accuracy of Book Value, so the onus is always on us the investors to verify what happens in our 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.

Friday, 4 April 2014

Canadian Aerospace, Waste Management and Engineering Companies - Sustainability, Social, Environmental and Governance Ratings

Today we continue the series of posts examining corporate sustainability, often called environmental, social and governance factors, of Canadian companies. In the past, we have looked at Consumer companies, Mining, and Oil and Gas stocks, and just last week, Transportation companies. It is now the turn of three more industrial sub-groups - aerospace and defense, waste management and engineering & construction firms. As in previous posts, we'll also have a look at their financial and stock performance.

The Methodology - 3 Key Factors
The data comes from reports like the annual Management Information or Proxy Circular filed on Sedar, or through a Sustainability report filed on the company website or on the Global Reporting Initiative database, on three key aspects that researchers have found (see especially the Mining post for the details and further links) are especially useful in finding companies that will outperform for the investor.

1) Board of Directors committee with a sustainability mandate
2) Executive compensation tied to ESG performance
3) Formal stakeholder engagement processes

We combine that data with other evidence that a company has been taking sustainability seriously:
4) Published, annual, up to date corporate sustainability reports, preferably audited and submitted to GRI
5) Membership in voluntary sustainability-related reporting and promotion organizations like Carbon Disclosure ProjectCanada's Top 100 EmployersCanada's Best Managed CompaniesSustainalystics / Macleans Top 50 Socially Responsible Corporations 2013Randstad Award for Canada’s Most Attractive Employer 2013
6) Constituent of the iShares Jantzi Social Index ETF (TSX: XEN) that holds only companies with better social and environmental ratings
7) High rating in the Board Shareholder Confidence Index published by the Clarkson Centre for Business Ethics and Board Effectiveness
8) Women on the Board of Directors

Sustainability Results
The results are similar to those for transportation companies - the larger the company, the more explicit and extensive the adherence to sustainability. In delving through the data we got the impression that many of the smaller companies may actually do more than is evident or documented or formalized. For example, smaller companies with a board of limited size may not find it necessary or cost effective to have a separate board committee devoted only to sustainability.

Surprisingly, no company seems to look green, aka good, across the table on every ESG rating dimension. Bombardier comes closest with a lot of green, but it doesn't have a board committee (see the three committees here) dedicated to Sustainability, not even one for Environment, Safety and Health, which comes closest as a partial effort for several others. Stantec is another that gives a better impression when we read through its latest Sustainability report than the absence of a dedicated board committee or explicit tied executive compensation would suggest. SNC's severe ethics failings of the last few years stand in contrast to the very green image our table presents. The various company reports suggest it is trying to rectify the problem but the question is, of course, whether that effort is genuine and will succeed. The experience of time will provide the answer.

Even more surprising, given that the companies are specialized in waste management, is that neither Newalta nor Progressive Waste Solutions, ties a significant part of company executives' pay to ESG performance. At least, it is not stated explicitly in the Proxy Circulars, where such data should be found.

Financial and stock performance seem opposite to Sustainability
The biggest surprise is in the next table, which sorts the companies by their annualized total stock return (capital gains plus reinvested dividends) over the last five years. Bombardier and SNC-Lavalin, which look so good in Sustainability, have had the worst stock performance, even worse than the benchmark TSX Composite's 12.0% annualized return, as represented by the iShares ETF that tracks the index under symbol XIC! All the other companies we show in these sectors (there are other smaller companies we do not show) have had consistent, solid profitability and profits.


A few of the stocks still seem value-priced according to Price/Earnings and P/Book ratios compared to XIC - Magellan and perhaps Bombardier. The other stocks appear to be priced in the expectation of further strong earnings growth. This suggests that an investor needs to look further into company prospects before buying in.

Bottom Line: Similarly to the results for Transportation, Oil & Gas and Consumer stocks, the research-established relationship between sustainability action and corporate success may take longer to manifest itself than the past five years. Nevertheless, this sustainability assessment may assist those investors who wish to select their investments on philosophical grounds in addition to the financial numbers.

Disclosure: This blogger owns shares of SNC-Lavalin.

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.

Friday, 28 March 2014

Canadian Transportation Companies - Sustainability, Social, Environmental and Governance Ratings

Just as we have previously done for Consumer companies, Mining, and Oil and Gas stocks, today we will take a look at how well Canadian firms in air, rail, truck and marine transportation rate on key corporate sustainability factors. We'll also have a look at their financial and stock performance.

Same Methodology - 3 Key Factors
In the same manner as before, we dig up data through reports like the annual Proxy Circular filed on Sedar, or through a Sustainability report filed on the company website or on the Global Reporting Initiative database, on three key aspects that researchers have found (see especially the Mining post for the details and further links) are especially useful in finding companies that will outperform for the investor.

1) Board of Directors committee with a sustainability mandate
2) Executive compensation tied to ESG performance
3) Formal stakeholder engagement processes


We also gathered other evidence that a company has been taking sustainability seriously:
4) Published, annual, up to date corporate sustainability reports, preferably audited and submitted to GRI
5) Membership in voluntary sustainability-related reporting and promotion organizations like Carbon Disclosure Project, Canada's Top 100 Employers, Green Marine, Canada's Best Managed Companies, Sustainalystics / Macleans Top 50 Socially Responsible Corporations 2013, Tour Operators’ Initiative for Sustainable Tourism Development, Randstad Award for Canada’s Most Attractive Employer 2013
6) Constituent of the iShares Jantzi Social Index ETF (TSX: XEN) that holds only companies with better social and environmental ratings
7) High rating in the Board Shareholder Confidence Index published by the Clarkson Centre for Business Ethics and Board Effectiveness
8) Women on the Board of Directors

Results
The results are a mixed bag. The pattern is, the bigger the company, the more explicit and extensive the adherence to sustainability.


No evident sustainability efforts - Cargojet, HNZ Group, Contrans Group, TransForce

Some sustainability initiatives - Air Canada, Chorus Aviation, Transat, Trimac, Algoma Central and Logistec

Integral to operations and strategy - Westjet, CN Rail and CP Rail. For example, CN's latest Sustainability Report, with its reams of pertinent statistics on environment, safety, people, and its priorization of issues in the chart reproduced below, provide convincing evidence that the company is doing more than paying lip service to sustainability.

Financial and stock performance not apparently related to Sustainability
The next table sorts the companies by their annualized total stock return (capital gains plus reinvested dividends) over the last five years.


There seems to be no relationship between sustainability rating and stock performance. (We note in passing that every stock but Transat has handily outstripped the return of the overall TSX, as measured in a benchmark fund such as iShares S&P  / TSX Capped Composite ETF (XIC), which achieved a compound return of 12.5%).

There are also seems to be no relationship between sustainability and company profitability, as measured by Return on Equity or Assets.

Bottom Line: As we noted before in the face of similar results for Oil & Gas and Consumer stocks, it may be that the research-established relationship between sustainability action and corporate success takes longer to manifest itself. In the meantime, the role of this sustainability assessment may thus be more to assist those investors who wish to select their investments on philosophical grounds in addition to the financial numbers.

Disclosure: This blogger owns shares of CNR.

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.

Friday, 21 March 2014

Picking Countries with a Weak Currency - How did it perform?

About a year ago in Using Weak Currencies to Find Foreign Equity Investment Opportunity, we wrote about research findings that found that equities in countries which had experienced prolonged weakness in their currency subsequently performed much better than the average. We dug up the data and identified seven individual countries and the Euro area, all of whose currencies had taken a battering. Let's now see what happened. Did those countries' equity equity markets do well for a Canadian investor?

The Eight Weak Currency Countries of Last Year - Win big or lose big
Last year's post listed available ETFs for each country and the Euro area, so we simply went to the ETF provider's website to get the return performance. Then we adjusted the return for the fact that since many of the ETFs trade in US dollars on US exchanges, the fall in value of the Canadian dollar (CAD) against the US dollar (USD) boosted results for a Canadian investor (i.e. each USD bought more and more CAD over the year). In fact, the USD went from buying $1.0285 CAD to $1.1065 between 1st March 2013 and 28th February 2014, a 7.58% rise, which is what we added to the returns for each of the US quoted ETFs.

1) Euro area:

That's an outstanding return, far ahead of a benchmark such as one for all non-North American developed countries, which happens to have a heavy loading of Euro holdings, the EAFE (Europe, Australia, Asia and the Far East) ETF from iShares Canada, iShares MSCI EAFE IMI Index ETF (TSX symbol: XEM). XEM's return was also outstanding but considerably less at +29.3%.

2) Denmark:
That's amazing return (imagine the TSX rising that much in a year!) and far better than the EAFE benchmark.

3) India:
These slightly different funds gave slightly different results. However, it is worth noting that the total return of the Canadian quoted funds, taken directly from the provider website, ended up in the same ballpark, after the CAD vs USD return is taken into account, as for the US-quoted INDY, whose USD return was -2.47% before the currency return was added. This demonstrates what we have noted before - that the currency change that matters is not the USD in which the ETF is traded but the shift between CAD the relevant country currency.

Note also that this positive return handily exceeds the return from the average of Emerging market countries in a benchmark fund such as the iShares MSCI Emerging Markets ETF (NYSE: EEM), whose total return was +1.0%.

4) Brazil:
This is far worse than the EEM benchmark.

5) Indonesia:
This is also far worse than the EEM benchmark.

6) Poland:
Another EEM benchmark beater.

7) South Africa:
And another EEM benchmark beater.

8) Turkey:
This is another massive under-performer of the EEM benchmark.

That's five winners and three losers in the weak currency sweepstakes.

There was a correspondence between each country's currency performance and the equity returns. Clicking through each country's one-year currency Visualizations Market Map chart on RatesFX, those with depreciating currencies with lots of bright red, like Indonesia, Turkey and Brazil, had poor equity returns, while those with good equity returns, like the Euro (chart image below), Poland and Denmark, saw their currencies appreciate - lots of blue on the chart.
(click to enlarge)
India and South Africa's currencies had strong bright red depreciation with modest though benchmark-exceeding returns. Last year they evidently hadn't yet hit the bottom of the currency path. Maybe the strong returns are to come.

The latest weak currency countries
Going through the same scan of the latest three-year currency performance on RatesFX, the countries with the telltale red of depreciation are:

1) Japan - Performance of Japanese equities was excellent in the 12 months ending February 28th, aided by the weak currency for a Canadian investor - up 21.3% in the iShares MSCI Japan ETF (NYSE: EWJ). Perhaps after many years of stagnation, market returns will remain positive. The Credit Suisse study we cited last year found that superior equity returns subsequent to currency weakness could persist for years. The valuation metrics on EWJ's webpage are moderately attractive - a fairly high Price/Earnings of 19.3 and a low Price/Book of 1.7.

Other ETFs to invest in Japanese equities, all traded on US stock markets, are listed in the ETFdb. There is only one unleveraged Japan-only equity traded in Canada, the iShares Japan Fundamental Index Fund (CJP), which is CAD-hedged, a feature that isolates market moves from currency moves in the short term, though it does impose a significant drag on returns in the long term, as we discussed in this post.

2) Chile - The equity market, as tracked by the iShares MSCI Chile Capped ETF (NYSE: ECH), did very poorly in the last twelve months, returning a huge decline of 25.2% for a Canadian investor. EWJ's valuation metrics are only somewhat appealing with a high P/E of 22.8 and a low P/B of 2.0.

3) Canada! - Except for other countries, several noted above, whose currencies are even weaker, the CAD has a weak track 3-year record against all major currencies (chart below). Choices of ETFs to invest in Canadian equity are many - see our reviews of Canadian large cap equity ETFs and a comparison of Canadian low-volatility with cap-weight ETFs.
(click to enlarge)

Valuation metrics of the Canadian equity benchmark iShares S&P/TSX Capped Composite Index Fund (TSX: XIC) are quite reasonable - a P/E of 16.6 and P/B of 2.0. Perhaps good returns are in the offing for investors in Canada's equity market.

Bottom line: Like all long term statistical relationships determined across many countries and multiple years, the one where weak currency presages stronger equity equity returns doesn't work without fail in every instance and it hasn't worked in the past year for every currency/country, only a majority of five out of eight. It also seems to be a "win big or lose big" proposition.

As for implementing a strategy to exploit the weak currency phenomenon, our post last year noted what we think are steps in a prudent approach. In addition,To adopt such a strategy is probably not for everyone. The best option for most investors who don't wish to take the time and trouble to track, then buy and sell the individual country holdings, is to invest in a few broad index funds like the benchmarks above (or the best in each category - see our comparisons of Emerging Market equity ETFs and diversified Developed Country ETFs).

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.

Thursday, 20 March 2014

Canadian ETFs with High After-Tax Cash Yields - Separating the Good from the Not so Good

Where does an investor find ETFs with a high after-tax cash payout? And what is the potential negative side of high payout funds, is there an Achilles heel? In general terms, the main potential negative is that a high payout may not be based on true investment return but merely be paying back the investor's own capital. Linked to this is the question of the likely future sustainability of the payout. What does the continued high payout depend on?

However, the first job is to find the funds. One place to start looking for such ETFs is a website like Best Dividend ETFs which posts a list of Dividend ETFs with Domicile in Canada that currently distribute a lot of cash. We've taken that list and added other funds that looked promising. Other promising funds can be unearthed by looking through the tax breakdown for the previous year that the ETF providers publish every year around this time for their own ETFs. The trick is to look for ETFs that have handed out tax efficient income, starting with return of capital (ROC), then dividends and capital gains. Interest income and foreign income are taxed at the highest marginal rate so those types of funds are less likely to distribute a lot after-tax.

To assess the best after-tax net return, we gathered data for ETF performance over the year 2013, incorporating three factors: i) the pre-tax payouts, ii) the tax breakdown of distributions as published by the ETF providers and iii) the tax rates that apply to return of capital, dividends, capital gains and foreign or interest income.

Today's post updates the review we did last year in two posts -   first, on the net returns in 2012 and second, on the likely sustainability of their high payouts. Redaders will note that many of the same high payout funds are on this year's list but that doesn't necessarily mean they are good choices.

The High After-Tax Payout ETFs
In the comparison table below, the results show how much cash return was received by an investor in the second highest Ontario tax bracket - $135,000 to $509,000 - or in a middle income bracket - $70,000 to $79,000 - in percent yield and in amount retained per dollar of cash received. There are some differences in ranking of the funds since higher rate taxpayers pay less tax on capital gains than on dividends while the reverse is the case for the middle income person, but the order is roughly the same.
(click on image to enlarge)


Many of the top payout funds in 2013 relied on bad Return of Capital (ROC) - The table highlights in red text the bad-ROC ETFs where the high tax efficiency and payout consists of large dollops of ROC and where the fund endured a net decline in Net Asset Value (NAV). As we have written in the past in the above linked posts and in the ever-popular Return of Capital: Separating the Good from the Bad, an ETF that merely pays an investor back his or her capital is not providing worthwhile performance.

Several other top payout funds have lost their advantaged edge - The grey shaded cells show the funds that last year lost their tax advantage when the federal government budget invalidated the transformation of interest income into capital gains by use of a forward agreement. Some funds ended the forward agreements later in 2013, like CVD, and others like CSD, CHB and HAF have adopted a transition strategy that uses the grandfathered existing forward agreement till expiry. Despite being allowed to continue for that limited time, their tax benefit will nevertheless be progressively diluted as new subscriptions enter the fund gaining normal interest that will be distributed as such to all shareholders old and new alike.

Call option revenue underlies a handful of high payout funds - Five funds - LXFHEX, ZWU, ZWB and HEF - rely on revenue from writing covered calls on their portfolio holdings to generate tax efficient extra income for distribution to shareholders.

Call option revenue is treated as capital gains but several of the ETFs in the table have no capital gains but lots of ROC. BMO's ETF Taxation background document explains how this happens: "From a tax perspective, the gains from writing options are combined with gains and losses from trading the underlying portfolio. If the underlying portfolio trades have generated losses, these losses reduce or negate the tax gain from the written options and create ROC." When that occurs, the fund may only be distributing cash equal to the sum of call writing income and dividends, but the NAV capital loss portion from trading losses is bad ROC.

Rising markets are key for a couple of high payout funds - Two funds - FIE and XTR - pay out a pre-set steady stream of cash that is partly based on unrealized capital gains, and thus becomes return of capital, from increases in the market value of holdings. In years when markets decline the ROC will be bad and in up years like 2012 and 2013, the ROC will be good. Long term success depends on markets rising more than they fall over the years.

Dividend stock focus explains the last group of high payers - Our table of the top 15 best after-tax payouts contains three funds whose high cash distribution depends on a portfolio of stocks paying healthy dividends - ZDV, ZUT and XEI. The funds merely pay out what they generate.

Major Canadian Index ETFs are tax efficient for middle income investors but not nearly as much for high bracket earners - For comparison we compiled the same data for some of the most popular Canadian equity index ETFs. The first thing we note is that generally the net after-tax payouts are much more modest, in the 2- 3% range across both income tax brackets. But the tax efficiency in terms of amount of each pre-tax dollar retained after tax is much better for the middle income earner, around 86 cents on the dollar, than for a a high bracket investor. The index funds mainly pay out dividends, which are taxed less in the middle income investor's hands.
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There is not much difference in efficiency between the highest cash payout funds and the index funds for the middle income investor. There is a great deal more difference for the high income investor - 72 cents on the dollar retained from the index fund payout vs as much as 90+ cents. The high payout funds with high efficiency are a much more appealing proposition for high earners.

Sustainability of cash payouts is a challenge for most high payout funds - Our next comparison table calculates the gap between the payout rate and the amount of income the holdings generate in dividends or interest net of MER. We have highlighted in salmon colour those ETFs where there is a substantial shortfall that must be made up somehow to avoid paying out bad ROC.
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Covered call writing ETFs need to generate the extra revenue primarily from the call writing. As we have discovered through seeing long term declines in NAV at most of these funds, it isn't easy. LXF, HEX, HEF and ZWU have all failed so far and suffered falling multi-year NAV. Only ZWB has managed to hold its NAV at least level.

But that ignores another key issue - ZWB is falling well short in total return performance. Compared to another ETF composed entirely of financial stocks, the iShares  S&P/TSX Capped Financials Index Fund (TSX: XFN) it has exhibited the flaw discussed by Rob Carrick in the Globe when the flurry of covered call ETFs were launched in 2011, namely that they are more or less fully exposed on the downside but only capture a portion of the upside. XFN's one year total return to the end of February is 18.5% vs only 12.7% for ZWB.

Two other funds - FIE and XTR - rely on a rising market to generate capital gains that are distributed unrealized to shareholders as ROC. This works in the long term and cash payouts are sustainable, as long as markets rise more than they fall. Some years the constant payouts the ETFs have set will exceed gains, or the market will go down, and the funds distribute what is hopefully temporarily bad ROC, to be caught up when the market goes back up. XTR was launched in 2005 and survived through the
financial crisis so maybe it is a viable strategy. Its five year total return of 17.0% to the end of February even handily beat the 13.7% of a common benchmark fund, the iShares S&P/TSX 60 Index Fund (XIU) . There is a tax advantage to receiving immediately non-taxed ROC (which is taxed later as capital gains when the investor sells the shares) so such a fund can make sense for taxable investors who want cash now.

Finally there are the funds holding dividend stocks like ZDV and XEI, which only distribute what they actually receive from the holdings, i.e. mostly dividend income. We had to cut the table off for lack of space but other dividend ETFs (reviewed recently here) like XDV, PDC, PDF are not far behind. Other funds with higher payouts that similarly only distribute what they receive like REITs and preferred share holding funds are also not far behind.

Bottom line - High payouts often come with the downside that more cash now means lower long term returns. Funds that distribute only what the under-lying portfolio generates naturally have a much better prospect of long term sustainability. As the old expression goes, it's not possible to make a silk purse out of a sow's ear.

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.

Tuesday, 11 March 2014

How to Avoid the Misery of T1135 Foreign Holdings Disclosure

When we last wrote about the T1135 Foreign Income Verification Statement, the form required by the Canada Revenue Agency when certain specified foreign assets of a Canadian taxpayer exceed $100,000 in cost, things were complicated enough. Well, things have got worse. The CRA is now requiring a lot more detail on the foreign assets and the rules as to when exactly the detail is needed or not have become even trickier.

A selection of articles on the T1135 trauma

Investors may well cry out - help! how do I escape this? Below we offer some suggestions for equity ETFs that escape the CRA net yet still provide foreign holdings for a portfolio. But first we need to narrow the task.

Amidst all the complexity, a few things are clear: 
1) Most notably for the majority of taxpayer investors, is that holdings within registered plans like RRSPs and other forms of registered retirement plans - LIFs, RRIFs, LIRAs etc, TFSAs, and RESPs are exempt from the necessity to report on the T1135, no matter what their value. 

2) Apart from these exempt accounts, what matters is not the currency of the holding, nor whether the broker is Canadian or outside the country, nor the stock exchange where the investment is bought or sold. Canadian company bonds denominated in US dollars are still Canadian. Royal Bank stock traded on the NYSE is still Canadian. US company stock held in a taxable Canadian discount broker account is still foreign. 

What matters is the domicile of the security, where it is registered. A mutual fund or ETF registered in Canada that holds foreign bonds or equities is still Canadian. 

Equity ETFs that avoid the T1135 rigmarole
We've sifted through the various ETF providers, like iShares Canada, BMO Financial, Horizons and Vanguard Canada who create bonafide Canadian registered funds that cover the broad passive equity indices covering the USA, Developed countries and Emerging Market countries worldwide. There are certainly many other qualifying ETFs from other providers such as First Asset, RBC, Invesco Powershares - see them all listed here on TMX Money - but we focus on the mainstream basic non-currency hedged portfolio building block funds. 

In the comparison table below, the T1135-avoiding funds are in green text. The three funds we like best within each geographic category are highlighted in green background.
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Note that many of the Canadian substitutes for US-registered funds have higher MERs and as a consequence have a higher tracking error i.e. tend to under-perform their respective index by a greater amount. On the other hand Canadian registered funds offer some advantages that enhance net returns, such as:
  • automatic, free distribution reinvestment;
  • avoidance of the need to exchange foreign currency since the ETF trades in Canadian dollars and handles the exchange internally much more cheaply than an individual investor can achieve (though a couple of the ETFs, ZSP-U and HXS-U, trade in US dollars in Canada on the TSX, and would thus not confer that benefit)
We did a few calculations using our free ETF comparison tool and found that the combined effects of all factors often gave quite close to the same net return for the Canadian-based and the US-based funds.

Our three favorites are:
Though it has a higher total expense load due to the combination of the management fee and the swap fee, the deferral of any tax until the investor sells shares plus the transformation of what would be annual foreign income distributions into capital gains can be very attractive in a taxable account. A Horizons fact sheet shows the benefit through a simple example.

International Developed  / Europe Australasia Far East equities - BMO MSCI EAFE Index ETF (ZEA)
The fact that it has a) a competitive MER plus, b) recovery of international non-USA foreign withholding tax by directly holding the foreign equities that is lost when a Canadian ETF holds a US-based ETF inside, is what wins for this fund.

Emerging Market equities - BMO MSCI Emerging Markets Index ETF (ZEM)
The reasons are the same as for ZEA - competitive MER plus no loss of withholding tax.

It should be noted that this fix for needing to fill in the T1135, if a person now already has assets that breach the $100k floor for reporting, cannot work immediately for a 2013 tax return, or even for a 2014 return. It can only be effective starting in 2015, since the rule is that it is the cost at any time during the year that matters, not what may be there at the end of the year. 

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.