Thursday 23 February 2012

Foreign Investments: What does history tell us about hedging currency?

Returns are boosted from investments in countries whose currency appreciates or reduced when the foreign currency depreciates ( walks through an example of how this works here). Should a Canadian investor looking at buying foreign equities or bonds therefore try to avoid the risk of shifts in the value of foreign currencies, for example by buying mutual funds or ETFs that hedge currency? It is an important topic since foreign diversification is on most people's agenda and we've previously posted on this subject several times: how a falling Canadian dollar softened the downward blow in 2008 and whether to hedge or not to hedge in relation to equities.

The recent publication of the Credit Suisse Global Investment Returns Yearbook 2012 adds new information with analysis on many countries worldwide in addition to the USA and Canada over a very long time period going back to 1900 and including bonds as well as equities. Here is what the Yearbook researchers found.

Currency exposure from foreign equity is a valuable benefit not a disadvantage for long term investors
Hedging benefits equity investments in the short term by dampening currency fluctuations but the effects fall off quickly with years invested and by as little as eight years holding period the effect of currency exposure as a protection against domestic inflation becomes a big benefit. As the researchers conclude, "Hedging thus exposes investors to rapid, unexpected inflation in their home country". That's because over the long haul, currencies reflect relative inflation rates. If Canada's inflation rises faster than in other countries the Canadian dollar will fall and that will boost foreign equity returns. That's a valuable benefit for long-term investors who are concerned about the purchasing power of their investments.

In the case of Canada in particular, the graph below from the Yearbook shows the Canadian investor in equities (pointed to by the red arrow on the left which we added to the original) would have had the lowest risk reduction of all from hedging - none at all in the period 1972 -2011.

The Yearbook tells us that:
  • "Cross-border bond investment offers lower diversification benefits than for equities, but adds currency risk"
  • " ... currency risk is proportionately larger when investing in bonds"
  • " ... short-term hedging is more effective for bonds"
Canadian Investors in foreign bonds experienced among the greatest risk reduction from hedging, as shown in the above chart by the red arrow on the right.

Hedging benefits fall quickly with investing time horizon
"Typically, the benefits fall the longer the horizon, and rapidly turn negative. Rather than lowering risk, hedging by longer term investors raises risk." As the Yearbook shows in figure 10, copied below, that can happen with a horizon as short as eight years for both bonds and equities.

Foreign equities and bonds performed best after currency weakness
A period of currency weakness in a country is more often than not followed by better returns for the foreign investor who held that country's equities or bonds.

That finding might suggest especially good moments to buy in. Does that mean, looking at the US dollar's weakness against every major currency, including the Canadian dollar, over the last three years in the Rates FX chart reproduced below, that now is the time to buy in to US investments?

It is tempting to see opportunity in the USA, especially since the US economy and stock markets seem at last to be on the rebound. However, the Yearbook warns us that anticipating future currency shifts is more or less impossible, let alone how the US market might perform. Averages do not equal certainty and do not guarantee a favorable outcome.

Implications for Canadian Investors:
1) Hedging foreign equities doesn't or shouldn't make much sense for two reasons. First, currency hedging only protects in the short term and in the long term, hedging raises risk from inflation - i.e. not hedging provides the additional benefit of protection against high domestic inflation. Second, anyone with a short term investing horizon should probably not be investing in equities at all, whether foreign or domestic. Money that will be needed in the next year or two should be invested in something much more stable than inherently volatile equities.

2) Hedging foreign bonds can make sense if the holdings are short duration bonds. The greater currency volatility effect on bonds makes hedging more valuable and the long term hedging disadvantage is not brought into play.

3) Wide diversification to many countries (i.e. not just the USA) and a longer time horizon together more or less eliminate the value of hedging foreign investments. Putting all foreign holdings in one country, like the USA, is not advisable from a currency risk viewpoint.

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 16 February 2012

Investing History Lessons on Inflation Protection and Market Mood Swings

Which investments protect best against inflation or its opposite, deflation? Does it make a difference whether inflation is lowish, say the Canadian government's target 2%, or very high at 8% or more, such as during the 1970s?

The renowned Credit Suisse Global Investment Returns Yearbook is now out in the 2012 edition (download here) and its principal authors Elroy Dimson, Paul Marsh and Mike Staunton have taken a look at the issue. Their research is uniquely valuable in two ways: first, they cover a very long time period, all the way back to 1900, so that world wars and the Great Depression are factored in; second, they include data for 19 countries, giving a much broader range of economic pasts and therefore possible futures than only Canada or the USA can provide.

What the Yearbook tells us is that each of bonds, equities, gold, home ownership have a different protection role and reaction to inflation.

Bonds provide protection against deflation (falling prices). Examine the graph below from the Yearbook, showing real / after-inflation returns. In periods when there is significant deflation (more than 3.5% drop in prices), bonds do extremely well, better by far than equities. On the other hand, when inflation gets to 8% or more (anyone remember the 1970s?) bonds get hammered. Disinflation - a decline in inflation rates - also benefits bonds.

Equities do quite well during deflation and up to a point of modest inflation, with real returns of 10 to 12%. However, equities offer limited inflation protection as returns tail off significantly even at what may seem to be modest inflation levels of 3+%. At hyper-inflation levels, equities char like toast. Equities are especially susceptible to sharp jumps in inflation. The main reason to buy equities pertains to the expectation, as established by the long history presented in the Yearbook, that equities will provide greater long term returns over bonds, the so-called equity risk premium.

Gold enters the picture as a possible investment to hedge against high inflation but it has been subject to very wide fluctuations in value that have nothing to do with inflation. In addition, its return is very low - 1% or so - but this may only happen over decades as its price may be underwater for many years and in the meantime it produces no income per se. In the short term, gold's returns do not respond directly and go up with inflation.

Inflation-linked bonds (known as real return bonds in Canada) explicitly protect against inflation through clauses that automatically ratchet up their value with inflation. The problem right now is that yields are minuscule (the Bank of Canada sample bond page shows a real yield average around 0.5% for long term RRBs) or negative in the USA, Britain and Canada. It's protection but that's all.

Commercial real estate, despite its tangible nature, as the authors say " ... is not an investment that should be initiated because of a new concern about inflation risk". The authors conclude that its value is for long term investment returns and diversification.

House prices do not reliably move in tandem with inflation though they seem to keep pace with inflation over the long term with real returns around 1%. There is also much variation amongst the few countries (Canada isn't included) for which much data exists. Furthermore, an individual person's house is not diversified in the manner of the aggregate index data the authors have used, which makes a house a riskier investment. A house is mostly a place to live - a consumption good - and much less so an investment.

Other assets like infrastructure, energy, utilities, timber and private equity they say simply lack data to show any reliable conclusion about inflation protection capability.

Investor Lessons
  • diversifying a portfolio across both bonds and equities is an essential strategy to protect against the range of environments from deflation to high inflation
  • inflation-linked bonds offer solid inflation protection but at the moment that's their only value as returns are close to zero
  • gold may be good inflation protection but you might have to wait decades
  • a house is mainly a home, not an investment

Risk appetite - the alternation of panic and euphoria
Greed and panic are said to motivate investors in a ceaseless ebb and flow. Anyone reading financial media constantly sees mention of investor skittishness or confidence. But how to measure the mood? Credit Suisse have taken a shot at quantifying the "market mood" with its Global Risk Appetite Index (GRAI), which the Yearbook illustrates with a fascinating chart, reproduced below. The basics of the Credit Suisse method, described further in the Yearbook, is to "... track the change in the relative performance of safe assets versus more volatile assets, e.g. government bonds and equities".

Investor lessons
The Yearbook's charts and discussion of GRAI give rise to several lessons for the investor:
  • wild swings from euphoria to panic or vice versa are a feature of the investing landscape and reversals often take place very rapidly; unexpected events are constantly happening. The investor should steel him/herself to this reality to help resist getting caught up in rash reactive sells, or buys, driven purely by emotion.
  • risk appetite is not just investors' imaginations at work; it is related to changing economic reality but more often than not it overshoots that reality by an excess of optimism or pessimism. At the moment, the GRAI is at a low ebb and is just recovering from its lowest recorded levels with a huge gap between risk appetite and actual industrial production momentum. Perhaps this indicates an investor buying opportunity in general or for specific companies. Back in August, when GRAI entered the panic phase, we posted our opinion that there appeared to be a summer sale on many companies. Get 'em while the bargains last?
  • no indicator is infallible and the Yearbook cautions against simplistic application to buy-sell decisions; sometimes the GRAI reflects what is only a short-term blip while at other times it shows when major market reversals are starting. Use other tools like fundamental analysis of individual companies (see our post here) or overall market valuation (see our post here). Warren Buffett, that most successful of investors, puts it well: "If past history was all there was to the game, the richest people would be librarians." (quote from Brainyquote) The Yearbook's review of GRAI is unfortunately a one-time glimpse since GRAI is a proprietary product restricted to Credit Suisse clients who pay for on-going access. The publicly-available poor man's version for panic vs greed is the VIX, the CBOE Market Volatility Index (Wikipedia description here, Yahoo quote here).

George Santayana once wrote (quoted in Wikiquotes): "Progress, far from consisting in change, depends on retentiveness. ... Those who cannot remember the past are condemned to repeat it." What we aim to do as investors is to learn to retain the bits that work and avoid the bits that do not. Let us remember the past.

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 7 February 2012

Save Tax by Income Splitting with RRSP, TFSA, Loans and Pension Income

Canada has a progressive income tax system whereby the higher your income the greater the percent tax you must pay. The range of rates goes from zero for very low income up to 50% for the highest earners in the most-taxed province of Nova Scotia. maintains a handy webpage with current (2012) tax rates in all the provinces and territories that show the breakpoint amounts for the eight or so steps in the tax ladder.

What is Income Splitting?
Spouses (or common-law partners) can lower their overall combined tax bill by shifting income from the high-income high-tax person to the low-income low-tax person, i.e. evening out, or splitting, income between the two people. For example, if $150,000 in earnings taxed at 43.7% in BC could be split $75,000 between two people and taxed at 32.5% there would be a tax savings of $16,800. The bigger the tax bracket difference, the more worthwhile the technique. However, the taxman doesn't want to be too generous and there are many restrictions by the Canada Revenue Agency (CRA) on income splitting. Here are some permissible ways to accomplish splitting.

1) Contribute to the low-income person's Spousal RRSP
Using his/her own RRSP contribution room, the high income spouse contributes to the other person's RRSP. The contributor gets to claim the tax refund, i.e. saving taxes at the higher tax rate. When the spouse eventually withdraws the funds it will be at his/her lower rate. The difference in contribution vs withdrawal tax rates can create a large saving. To see how beneficial this can be, consider the simple example below, where we take an Ontario couple at opposite ends of the income scale - one at the highest rate 46.41% and the other at the bottom rung of 20.05% (figures from TaxTips). There is an impressive tax savings of almost $5300 on a withdrawal of $20,000. That's even before considering the potential tax-free gains of the investments within the RRSP, which is the primary purpose of RRSPs and a great benefit in itself.

An important caveat: the recipient spouse must not withdraw the funds during the year of contribution nor the following two calendar years, otherwise the CRA simply taxes the amount in the hands of the contributor.

Note that the Spousal RRSP method's advantage lies mainly for withdrawals before age 65 since after retirement (age 65+) the next strategy we describe allows RRSP-derived income to be split. However, the Spousal RRSP is still useful after retirement since it effectively allows all of the retirement income for that contribution to be transferred to the low income spouse. This can be useful to reduce total family taxes if, for example, the high income spouse has non-registered investments that cannot be split. In that case it is advantageous for the low income spouse to keep all or more of the Spousal RRSP withdrawal for taxation in his/her hands.

2) Split eligible pension income
A person 65 or over is allowed to transfer up to half of something called eligible pension income to a spouse. If the older person has higher income, this enables amounts to be taxed at the lower bracket person's rate and saves tax overall. The recipient spouse need not be over 65. No actual cash needs to move from one spouse to the other, the adjusted income amounts are simply declared on the tax returns of the couple and CRA form T1032 to fill in. As BMO Nesbitt Burns suggests in its pamphlet on pension income splitting, there may be also be a benefit for the higher income spouse through preventing OAS clawback.

Eligible pension income is a strictly defined term and includes withdrawals from a RRIF (when the person withdrawing is at least 65
) but not from an RRSP i.e. the RRSP would have to be converted to a RRIF. See for further detail on the general criteria for pension income splitting and on what qualifies as eligible pension income. The official CRA info on pension income splitting is here. Readers may also find helpful interpretation of their own situation or questions from the Ask-Fred page of the financial advisor firm Canada Retirement Information Centre Inc.

Converting at least some of an RSSP to a RRIF (it isn't necessary to convert all of an RRSP at once and it is possible to have both RRSPs and RRIFs in existence at the same time) for those 65 gives the opportunity to use the pension income tax credit. The tax credit eliminates tax in the lowest tax bracket, or substantially reduces it in higher brackets, on the first $2000 of eligible pension income. When both spouses are over 65, the possibility to split income and to use the credit for both people, or to transfer unused portions from one person to the other, can save more in taxes.

3) Split CPP income
Though CPP is specifically excluded from the list of types of eligible pension income mentioned in the previous strategy (because the CRA wants it not to count when figuring out the pension income tax credit), it is possible to split CPP, or share it, as the government puts it on the Service Canada Sharing your retirement pension page where the details of how it works are explained. Read the rules carefully, since not all of the CPP may be eligible for sharing if you did not live together the whole time CPP contributions were being made. Blue Chip Advice has an excellent chart that neatly shows the combined effect of CPP and pension splitting for an Ontario couple.

4) Contribute to spouse's TFSA

If your own TFSA and RRSP contribution room has been used up, then putting money into a spousal TFSA places savings into an account where tax-free growth can occur. There is no tax deduction as for an RRSP of course, but the alternative of investing the funds in a regular taxable account is less advantageous (see our previous post comparing investing through an RRSP or a TFSA versus a non-registered taxable account. And, the spousal TFSA contribution avoids the income being attributed back, and taxed back, in the hands of the high income spouse, which would happen if the funds went into a non-registered taxable account, whether in the name of the low income spouse or not.

5) Loan money to spouse for making investments
If the high income spouse loans money to the low income spouse, the gains or income will be taxed in the latter's hands. The loan must meet certain conditions for CRA to consider it legitimate and not simply tax the high income donor, such as: a) documenting this arrangement with a written loan agreement like a promissory note that specifies principal amount and interest rate on the loan, b) actually paying the interest no later than January 30th each following year and c) charging interest at least equal to the rate prescribed by the CRA (the one labelled "for employees and shareholders from interest-free and low-interest loans") The prescribed rate at the moment is only 1%! That rate can be locked in for the life of the loan even though the prescribed rate later goes up - at some point it will rise since today's record low interest rates cannot remain so forever. One drawback pointed out by TaxTips is that savings are modest unless the loan is substantial. An inheritance received by the high income spouse is one example where this strategy could be applied. One method that does NOT work is for the high income spouse to give the money to the low income spouse. Under CRA's attribution rules, the CRA would deny the low income spouse's attempt to claim any income from the inheritance/gift as his/her own and would tax it as income of the high income spouse.

6) High earner pays household expenses, low earner invests
Whether it is groceries, mortgage payments, credit card bills, car payments, even income tax owing by the low earner, when the high bracket person pays such expenses the low earner can invest and all the income gets taxed only in the low earner's hands. The high bracket spouse can even pay the interest portion, but not the principal, of a third party loan for investment taken out by the low earner. The interest payment must have a clear paper trail to the high earner only, like a personal cheque. A separate account could certainly help.

7) Transfer dividends to the high income spouse
This counter-intuitive tactic can help when the low income spouse has such low taxable income that no tax would be payable and the dividend tax credit might go unused. To be allowed to do this the high income spouse must thereby be able to claim a larger spousal tax credit. Even when such a transfer is possible, there may not be a net benefit. The only way is to do the calculation both ways. This caveat brings up the next point.

Run the numbers and consider getting advice before proceeding
Due to the complexity of our tax system, many of the techniques above can seem to have the effect of that famous arcade game Whack-a-Mole (see YouTube video of someone very good at it). No sooner do you push down taxes with one tactic but it has the effect of raising income or reducing deductions that push taxes back up elsewhere. While generally working as described, individual circumstances of couples might not result in much or any tax reduction.

One convenient way to try things out is with the best of the tax preparation packages. The best packages don't just transcribe your data entries onto the correct lines, they try to figure out what combination of claims, transfers and deductions will give the lowest tax (see CanadianFinancialDIY's review of the packages last year; this year's review is not yet out). Both spousal returns must be done simultaneously in the same package of course. In the online web versions of the packages, you can enter all the data and see the net results before paying (though you must pay before getting filable or printable format data). Another tool to do what if scenarios is TaxTips's quite detailed Canadian Income Tax Calculator.

The other way to be sure of your step in carrying out these strategies is the ever-wise consultation with a professional, a tax accountant in this case.

Spousal equality is a social and personal ideal pursued by many. Spousal equality of taxable income certainly pays off in lower taxes.

Disclaimer: this post is my opinion only and should not be construed as investment or tax advice. Readers should be aware that the above comparisons are not an investment or tax 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 3 February 2012

Preparing to File 2011 Tax Return - Guide for the Canadian Investor

The annual RRSP ad campaigns now in full swing should be the reminder to Canadian investors to start getting ready for filing their 2011 income tax return. There can be a multitude of slips and receipts to assemble, not to mention older records to dig up and preliminary calculations to do in order to be ready in time for filing on or before the deadline of April 30 set by the tax collector, the Canada Revenue Agency (CRA in our table below). We therefore present a calendar checklist that shows what type of documents to expect when and from whom, along with key dates.

2011 throughout Investment interest expense on funds borrowed to invest appears on statements from broker for margin, or bank for loan


January mid CRA pdf tax forms for printing available for download at

February start T3 slips for mutual funds mailed directly by Mutual fund companies, NOT brokers, even when fund is held in a brokerage account. Online list and links to companies at

13 CRA online filing service NetFile starts accepting 2011 tax returns – certified software list at
Web software packages reviewed and rated by CanadianFinancialDIY – see last year's results at

continual CRA issues tax refunds, often within days, if return is filed electronically

mid ETF providers publish tax breakdown on their website. ETF providers in Canada list and links at
Note that broker sends out official T3/T5 receipts for ETFs but investor must track own adjusted cost base – see
Income Trusts, which often distribute Return of Capital, have same tracking challenge

mid T4A Educational Assistance Payment slips from RESP sent to beneficiaries by brokers or financial institution where RESP is held

mid T4A and T5 slips for registered or non-registered annuity payouts mailed by insurance companies

end Brokers mailout tax package with T5 slips, T4A, T4RSP, T4RIF, T4LIF, T4LIRA withdrawal slips. Part of package is detail of Trading Activity an essential for calculating capital gains. Prior year statements may be required to establish the adjusted cost base of an investment if buy and sell dates in different years.
Bond, GIC, CSB, term deposit, interest on cash deposits less than $50 may not show on a T5 but still must be reported; refer to transaction statements to find the amounts
T-Bill and Stripped bond returns need the trading activity to calculate the interest to be reported (redemption/sale amount – pruchase cost) since T5 does NOT show it, even when over $50 e.g.

end RRSP contribution receipts - brokers & mutual fund companies issue 2011 tax receipts for contributions during Jan 2012

29 RRSP – last day for making contribution for 2011 tax year

March end Brokers mailout T5s for Split Corps

end T3 trust slips mailed by brokers; laggard REITs, Income Trusts, Royalty Trusts and Limited Partnerships often responsible – see

end T3 or T5 slips for mutual funds mailed directly by Mutual fund companies, NOT brokers, even when fund is held in a brokerage account

end RRSP contribution receipts - brokers & mutual fund companies issue 2011 tax receipts for contributions during Feb 2012
April 30 CRA – last day to file 2011 return and pay amounts owing to avoid penalties

June 15 CRA – last day to file 2011 return for self-employed though amounts owing deadline is still April 30

September 29 CRA – last day for online filing service NetFile to accept 2011 tax returns

Note that apart from rigid CRA dates, our list of timings is approximate - there can be weeks or more of variation amongst companies that issue the slips and receipts. If in doubt check the website or phone the company involved but don't leave it to the last few days before April 30. It is likely to be hard to get a response in time to file.
In addition to the above calendar, we also refer blog readers to previous posts that can help with preparing taxes: Tax Resources and the 2011 Investor Calendar's many links to Tax Topic Resources. These posts include links to general tax websites that cover other personal tax items that we have ignored here in our focus on investing.

One special note: Preparing and filing electronically makes much sense. Not only does any refund come much faster but the best of the software packages really help ensure you do not miss or mis-report anything and they may even find deductions or optimizations that save you money.

Though we cannot really go so far as to say you should enjoy the experience of preparing your 2011 return, hopefully we have provided enough information to make the task, in true Canadian parlance, "not unpleasant".

Disclaimer: this post is my opinion only and should not be construed as investment or tax advice. Readers should be aware that the above comparisons are not an investment or tax 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.