Friday, 30 March 2012

How to Calculate Capital Gains and Other Income Taxes on ETFs

With a month to go before the April 30th income tax filing deadline and with T3 and T5 slips due any day from brokers (see our recent tax calendar post with all the key tax dates for investors), the investor needs to be ready with the correct method for filling out tax forms, especially the tricky bit of calculating capital gains on ETFs.

Example Situation - To demonstrate the ins and outs and variations possible that can be applied generally to all ETFs, we use the example of an ETF that holds US Large Cap Equities but is traded on the TSX in Canada:

Investor buys 1000 shares of XSP on August 2nd, 2011 and then sells them on January 3rd, 2012 in a taxable non-registered account. What happens and what needs to be done on tax returns?

Entering T3 or T5 Boxes on Your Tax Return - First, there are no tax returns to worry about for XSP held within a tax-sheltered account such as a RRSP, RESP, TFSA, LIF, LIRA etc. There are indirect tax consequences explained further on in this post but we start with XSP held in a taxable account.

T3/5 entry is the easy step and it covers all of what you need to do to complete your 2011 tax return. If there is information to report because you hold this or any other ETF in a taxable account, your broker (and not the ETF provider) will send you T3 or T5 slips. Doing your 2011 return is as easy as transferring the amounts from each box into the return where the form or tax software asks for each one. Box 34 contains foreign taxes paid to the USA; you get a tax credit for that amount, which will reduce Canadian taxes owing.

The only box that doesn't get entered on the 2011 return is box 42 Return of Capital, which you only use to calculate an updated Adjusted Cost Base (ACB). The screen image below shows how a T3 as it applies to XSB would appear for you the investor in the 2011 tax year.

Capital Gains Reporting - There are two sources of capital gains within an ETF that an investor might need to report.

1) Gains internal to the ETF: As a result of trading by the ETF managers, for example to rebalance or replace holdings following index changes or sometimes from unintended profits of currency hedging activities (e.g. XSP in 2010), the ETF might end up the year with net capital gains. There could also be net losses for the year but as a trust, under Canadian tax rules, an ETF cannot distribute capital losses to investors, it can only accumulate and carry them forward to offset future gains. Those gains the ETF distributes or attributes to investors for tax purposes and they show up in box 21 on the T3. The investor receives no cash, in fact ETFs reinvest the capital gains. Note that box 21 Capital Gains is blank for XSP in 2011. In past years there have been very large capital gains by XSP for the investor to report, notably in 2007 and 2010, as the Distributions tab for XSP on the iShares website copied in the screen image copy shows.

2) Gains the investor creates by buying and selling shares: This is the more obvious and intuitive source of capital gain. But it trickier to calculate correctly for income tax reporting. Applying to XSP the general method we explained in ETFs and Mutual Funds - Calculating Capital Gains, the table below shows the amounts to report spread over 2011 and 2012 tax returns. The formula is:

ACB = Total Paid to Purchase Shares/Units (minus fees and commissions)
Reinvested Distributions
Return of Capital (ROC)

In both years box 21 is blank but for the 2012 return, the year XSP is sold, the investor must report a capital gain on Schedule 3. The red highlighted lines show the two sources of capital gains.

In calculating the gain, there was no reinvested distribution, which we know from looking at the XSP distributions. Unfortunately, and unlike the other required ACB adjustment, return of capital, which appears in box 42, the T3 does not show the amount of reinvested distribution for the year. Reinvested distribution can only be found on the ETF provider's website in the distributions detail. Adding the reinvested distribution to ACB, though most often a small amount, benefits the investor since a higher ACB means a lower capital gain to report. An important caveat is that the box 21 Capital Gain does not necessarily equal Reinvested Distribution, though it is the main driver of it and often is equal to it. An entertaining lengthy dissection of this potentially confusing point can be found in this Financial Webring thread.

No capital gains double counting occurs - Some might think that capital gains tax is being levied twice, once through the annual box 21 and secondly through the gain on sale. That is not the case. The reason is that you are able to offset the capital gains that are reinvested within the fund (the type that gets into box 21 on which you pay tax annually) by adding the reinvestment amount to your ACB.

Adjust ACB for every year - If you have owned an ETF for several years and then sell it, be sure to include the ACB adjustments for all the years, not just the most current year.

Reinvested distributions happen only at year end - Also, what counts is whether the shares were owned at the final year end distribution record date, since that is when the ETFs distribute capital gains and attribute the reinvestment, not in any other monthly, quarterly or semi-annual distribution. If you buy in January and sell in June, you cannot add the reinvested distribution for the year, nor some pro-rated amount.

Other tax categories of income happen unevenly at any time of year - Return of capital, however, may occur throughout the year. In 2011, XSP paid out 0.00419 ROC per share in June and 0.00649 in December. Our source is iShares' 2011 Tax Distribution Characteristics, which breaks down each type of income by payment. That is why our XSP example T3 only reports 1000 x 0.00649 = $6.49. It was only bought in August and missed the June ROC. Similarly, foreign income (box 25) and foreign tax paid (box 34) for XSP is split unevenly between the June and the December distributions, so our T3 reflects that fact. Other ETF providers, unlike iShares, do not publish the tax breakdown within each year. You as an investor need not worry about it since the broker is responsible for preparing and sending out a T3/5 with the correct data.

Cash distribution amounts don't matter for tax calculations - The actual cash distribution for XSP of $143.11 received during the time XSP was owned will not show up on a T3/T5 slip. Cash is irrelevant for taxes. The total of cash plus reinvested distributions in the upper part of the XSP distribution table must equal the sum of the tax breakdown in the lower part of the table (i.e $0.23557 per share in 2011 for XSP) but there is no necessary one to one correspondence between amounts like cash and any particular tax category. Ignore cash and use the T3/5 slips.

Foreign tax paid by XSP is not claimable in registered accounts - There are different tax consequences for XSP within registered accounts - RRSP, RESP, TFSA, LIF, LIRA etc. There is no T3 issued in such registered accounts for any holdings, whether consisting of XSP or any other ETF. There is no way to obtain a tax credit for the foreign tax amount that would appear in box 34. It has been deducted in the USA before reaching iShares. The effect is a permanent real reduction compared to the under-lying S&P 500 Index to XSP's return for the investor that repeats every year XSP is owned.

In our next post, we will compare XSP with four other ETFs in the same US large cap equity category and see how they have significantly different tax profiles, enough perhaps to sway the choice of which is best for particular investor circumstances.

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, 23 March 2012

Canadian Large Cap Equity Index ETFs Update - Surprises for Investors

Diversified large cap equity index ETFs are a key building block of the portfolio of most investors. When we last looked at this category of ETFs in September 2010 (see also original comparison in December 2009), the Horizons BetaPro TSX 60 tracker (TSX symbol: HXT) had just joined the fray. There have been some significant changes since:
  • HXT looked like an intriguing concept but it had no track record to judge it by. Now there is eighteen months of data. How is it doing?
  • Massive US-based fund company Vanguard has launched a Canadian operation and a flagship fund in the large cap space, the Vanguard MSCI Canada Index ETF (VCE). Does it look attractive and how is it likely to perform versus the others?
  • Horizons in June 2011 merged the AlphaPro Managed S&P/TSX 60™ ETF (HAX) into the Horizons AlphaPro S&P/TSX 60 Equal Weight Index ETF (HEW). Is it doing any better than the weak performance of HAX?

We look at these questions while comparing all the ETFs' total return performance and examining what caused the returns to differ. There are six large cap equity ETFs to consider:

Total Return Performance

First, we note that the true performance of these ETFs, as with any investment, is the total return composed both of capital appreciation and dividends/distributions. The Globe's John Heinzl explains what total return is and why it matters in a short video here. A second note is that ETF performance is evaluated based on Net Asset Value or NAV, which is the sum of the values of all the holdings within the ETF, as opposed to the actual market price of the ETF, which bounces up and down slightly above and below (the slighter the better) the NAV. Investopedia explains a bit more here. shows the monthly variation price above NAV (premium) vs below (discount) in its ETF quotes e.g. for XIU here.

In our comparison table below, we see that the return winner is clearly CRQ – Claymore Canadian Fundamental Index ETF for its significantly superior returns (green numbers) over all but one timescale (except year-to-date up to Feb.29th 2012). Claymore's website promotional material (e.g. it's Better way to invest paper) claims that its fundamental weighting indexing method is a "better mousetrap" that will outperform. Maybe there is some truth to the assertion, though even five years is not a sufficiently long time to reach any firm conclusions. A big surprise is that CRQ's considerably higher MER fee of 0.71% has not knocked its returns below those of other ETFs with much lower fees. It defies a good investing rule of thumb that a lower fee, especially when it comes to autopilot index funds, leaves the investor better off.

HXT seems to be successful so far in carrying out its announced mandate to provide the investor with the TSX 60's return net of its fees. Its returns have indeed been the amount of its 0.07% annual fees below the TSX 60 returns.

What's inside - financial services, consumer staples, materials, telecommunications - makes the difference - Our next table below shows the internal composition of the ETFs that have made a difference in performance and will continue to do so. The dark purple numbers in the CRQ column indicate the industry sectors where there is a substantial divergence between CRQ and the standard benchmark TSX60 index and the ETFs that align deliberately (XIU, HXT) or in fact (ZCN, VCE) with it. CRQ contains a much heavier weighting in financial services and consumer staples and a much lighter weighting in materials and telecommunications. This has been the case for some years. As the Canadian banks have regained some market favour after losing it during the financial crisis, CRQ has benefited more than the other ETFs.

A few companies are key differentiators - Some very large companies that are either absent entirely from, or with vastly different weighting within, the various ETFs are the key driver of performance variation - notably Fairfax Financial, Manulife, Power Financial, Onex, Great West, RIM, Manulife, Sun Life, BMO, Barrick Gold, Canadian Natural Resources, Potash Corp, Goldcorp, BCE, Telus and SXC Health Solutions. See our recent Market Darlings and Dogs post for more detail.

Weightings moving closer - The weightings amongst all the funds but HEW have moved much closer together in the last few years. The little up ↑or down ↓arrows beside the industry sectors shows whether each weighting has moved up or down since our last review. The biggest sector, financial services, has gone up in XIU and ZCN and down in CRQ, bringing them much closer together. Materials, or mining, is now the biggest difference and will be a big driver of future return differences.

Performance doesn't necessarily attract investor money - Investors must not have noticed CRQ's performance, or perhaps they believe it cannot be sustained, since its asset base has remained stagnant. Meanwhile the much more recent start-up ZCN has leaped upwards in assets, attracting as much investor money in the 18 months since September 2010 as the entire size of CRQ.

VCE, ZCN and XIU/HXT are peas in a pod - The fact the new entrant VCE very closely mimics the TSX60 and therefore XIU and HXT as well as ZCN in its asset allocation among sectors and top holdings means that its future performance should follow closely too. VCE has garnered a reasonable $45 million in assets in the few months since its November inception. The very low 0.09% annual fee makes it a solid choice.

HEW will see its returns diverge - HEW's similar performance to the TSX 60 in the one year for which data is available should not be expected to continue. In the long term, the drastically different weighting amongst sectors and companies should cause its performance to diverge from the others. However, the tiny $8 million asset base of HEW is really not viable in the long term however so unless Horizons manages to catch investor attention, it may not be around for many years.

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, 15 March 2012

The Best of the Online Investing Discussion Forums

Our last post about the recent troubles of SNC-Lavalin gathered together financial data, analyst comment and mainstream media stories. Suppose that leaves you feeling not sure whether this is a good time to buy in or, if already a shareholder, to sell your holding, hang on or buy more on the price decline. Suppose you want to widen the body of opinion even further and find out what fellow investors think. The best way to find out is through online discussion boards or forums.

What is a Forum or Board?
A Forum a website where anyone can post information on a topic. Topics are organized as threads. A person will start a new thread, which others then comment on or respond to, creating a series of posts. Posts can be as short or long, though most of the time, there is short and quick back and forth exchange. The thread is not a live chat session; posting is done by an offline message. Though you can simply read what others have written and not post yourself, it is easy to get involved in discussions through a simple, free and quick sign-up. It is not necessary to use your real name in your online identity, which allows you to remain anonymous to others and in fact, most people use a pseudonym. There are always forum administrators or moderators operating the boards and they enforce rules of behaviour and content. Wikipedia describes in more detail how Internet forums work. There are forums on many subjects but the ones we have selected below focus on investing and personal finance.

What do Discussion Boards offer?
Arlo Guthrie's classic song Alice's Restaurant (listen to it here on YouTube) contains a good answer: "You can get anything you want ...". Click on the links to the forums listed below and you will find all the major topic areas of interest to the individual investor:
  • ETFs, mutual funds , closed end funds, split shares, REITs
  • individual stocks, preferred shares, GICs, corporate bonds, government bonds, real return bonds
  • currency exchange
  • portfolio construction, rebalancing, asset allocation
  • taxes
  • financial planning, retirement planning, estate planning, annuities, insurance
  • discount and full service brokers, financial planners, software
  • RRSP, TFSA, RRIF, LIF, RESP, LIRA, non-registered accounts
  • economy, market trends
  • etc
A huge advantage of forums is that if you cannot find the answer you seek in some existing thread, you can post a new thread and ask others to help out. Usually someone steps forward often and many do.

Pros and Cons
The cornucopia is not necessarily a panacea! Boards contain a mix of gold and fool's gold.

  • Free - no cost to register and be able to post at any of the sites; reading only does not even require registration
  • Anonymity possible - post questions and comments without having to reveal to others who you are
  • Unbiased - fellow investors, with nothing to sell and the same interests as you, make up the vast bulk of forum participants, though of course there is nothing to prevent industry people to post and some do; if things turn to promotion other users and the moderators will step in to stop it.
  • Expertise - some of the forum community members have considerable knowledge and they seem to take pleasure in sharing it; it may take a bit of time and reading of many posts to figure out who does and who does not know what they are talking about though. When something gets written that isn't correct or is dubious, there is often someone else ready to step up and dispute the matter.
  • Fun - part of the payoff for actively taking part in a forum is the chance to share and discuss a subject of interest with like-minded people. Apart from its practical side, investing can be an enjoyable mental activity, almost a type of game.
  • High Chaff to Wheat - like anything else human, there is a lot of un- or poorly-informed opinion expressed in the threads. It may be necessary to read many posts to find a few bits of useful information. The search tools within each forum can help to reduce that somewhat. After a while it becomes evident which forum members are better informed and more worth reading. The dark side of the anonymity allowed in a forum is the opportunity for dishonest people to deliberately give misleading information. Caveat lector, always.
  • Time Consumption - a corollary of the above point is that it is very easy to burn up a lot of time reading through oodles of posts. It is easy to get distracted and off onto tangents.
Favorite Forums - The best online boards have many registered users and high volumes of posts, producing a breadth and depth of discussion that will cover from the highest level view to drill down to the smallest detail anyone could want.

Financial Webring - Canadian focus and perspective, very active forum; features a number of users with credibility, such as Bylo Selhi (website here), Keith Beatty aka Shakespeare (website here), James Hymas (website here), Bruce Cohen (co-author of Pension Puzzle), Norbert Schlenker (advisor at Libra Investment Management), Norm Rothery (Stingy Investor website here) and others.

Canadian Money Forum - Canadian focus as well, more recent startup by Ram Balakrishnan author of the popular CanadianCapitalist blog on Canadian MoneySense and Mike Holman (aka Four Pillars, Money Smarts blogger); very active blog; also features users like Alexandra Macqueen, aka MoneyGal (co-author of Pensionize Your Nest Egg), Financial Post journalist Jon Chevreau (blog here book Findependence Day)

Bogleheads - USA focus but lots of general investing content useful to Canadians; named after Vanguard founder John Bogle, many of its users admire his low-cost passive indexing philosophy; huge message volumes. Sample thread: World's Worst Stock Market Losses.

Motley Fool - USA focus but has a somewhat active Canadian section; notable for the number of pre-set categories for posts, which can help narrow a search for specific content instead of using the site's search tool, which is the main method to find topics on other forums; dedicated area to discuss industry sectors

DRIP Investing Resource Center - specialized focus on dividend reinvestment, covers both Canada and the USA.

Small Investor Protection Association - specialized focus on Canadian investor protection, fraud avoidance, fighting for restitution when problems arise, e.g. the thread Solutions, Self-Defense and Best Practices

As for SNC-Lavalin, the official company response on any potential further financial adjustments, promised by the end of March, has not yet been released but in the meantime, we can keep up with opinions on SNC-Lavalin on this Financial Webring thread and here on Canadian Money Forum. Of course, talking about SNC won't change the eventual outcome, so let's hope that the boards' benefit will not be reduced to the small comfort of the old cliché, "misery loves company".

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, 9 March 2012

SNC-Lavalin: More trouble ahead or buying opportunity?

At 7:32 am on February 28th, engineering giant SNC-Lavalin (TSX: SNC) issued a blandly titled press release about revisions to 2011 financial results. Though the amounts involved were small for a company SNC's size, at the open of trading, SNC's stock dropped 20% and it has not recovered since as the screen capture below from Google Finance shows.

Investors are wondering (disclosure: including this blogger who owns some SNC shares) - are we looking at the beginnings of another Nortel, Bre-X or Sino-Forest disaster, or is this a one-off bad knock to a solid company that will recover? Ray Turchansky's Keep your head when a stock stumbles to a loss in the Edmonton Journal talks of some past stock disasters and survivors. He gives sensible advice about the kinds of factors to weigh before buying a bargain on the dip (some dip!) or selling out before worse news ensues e.g. is it a one-off event by a rogue person or two, or a widespread corporate culture issue; what effect will it have on current and future financial statements; how does management react? Unfortunately, he does not provide any answers to the questions ... so we will go searching for relevant information to try to fill the gap.

The Problem Situation
  • "A loss of approximately $23 million from a revised position of the Company's net financial exposure on its Libyan projects; Unfavourable cost reforecasts on certain projects in its Infrastructure and Environment and Chemicals and Petroleum segments; and Period expenses of approximately $35 million relating to certain payments made in the fourth quarter of 2011 that were documented to construction projects to which they did not relate and, consequently, had to be recorded as expenses in the quarter" (from the press release). This represents an 18% reduction in 2011 profits. There is an ominous reference in the press release to on-going investigation of "certain other contracts", suggesting more adjustments will be made.
  • A few weeks earlier on February 9th, two senior executives suddenly left the company without explanation (press release here). One of them, Riadh Ben Aïssa was Executive Vice-President, reporting directly to the SNC CEO and had been in charge of operations in Libya.
  • A Quebec law firm seeks to launch a class action lawsuit against SNC for $250 million in damages (see this Financial Post report of March 3)
  • A securities analyst cited in the Financial Post article speculates that for SNC to fix its problems might cost $300 million on things like investigation, fines, severances, legal defence, new monitoring and control systems.
Widespread Corruption?
  • As the result of a World Bank request, the RCMP in September 2011 raided SNC's Toronto offices (per the Wall Street Journal) in an investigation of allegations of bribery in seeking a contract in Bangladesh. No charges have been laid and there has been no further news.
  • Google searching for the words "SNC, corruption, bribery" brings up only a power project in India from the 1990s in addition to Libya and Bangladesh.
  • SNC was close to the former Gadhafi regime in Libya - see January 14th Globe and Mail, March 1st CBC News. So far, there seems to be no police investigation into SNC's Libyan activities.
Accounting Shenanigans?
  • Of the list in our previous blog post about financial manipulation fraud warning signs, SNC matches a couple - the unexpected departure of senior executives and the delay in financial statements. The other indicators of bad accounting don't match SNC.
  • Martin Fridson and Fernando Alvarez' book Financial Statement Analysis mentions various tests of financial statement numbers for manipulation and fraud. SNC matches one - growing sales, but exhibits data strongly opposite to fraudulent statements on the other measures - number of days' sales in receivables (down instead of the worrying up), asset quality trend, trend in depreciation and gross margin evolution (see many of SNC's good looking financial metrics on ADVFN)
  • Deloitte and Touche have been SNC's auditors for years and have not issued any reservations with regard to financial statements, nor have they bailed out yet following the recent developments.
Governance and Ethics, Good or Bad?
  • The Board of Directors, through its Audit committee, not management, has taken charge of the investigation as the SNC press release noted. That the Board should lead makes sense given that management's possible role or complicity in any wrong-doing is one of the bigger questions at the moment. SNC has a substantial Code of Ethics and Business Conduct but is it generally followed and enforced?
  • The Board's involvement apparently began after an anonymous SNC insider sent a letter making allegations in December 2011 according to this CBC News report of February 28th. The Board responsiveness could be taken as encouraging though it leaves open the question of how the improper activities could have arisen in the first place.
  • A Bloomberg Business Week article by Diane Brady asks about SNC, When did the moral compass break? It cites Libyan ties and suggests there may be some with Syria.
  • The latest annual ratings of Board quality by the Clarkson Centre for Business Ethics and Board Effectiveness at the U of Toronto Rotman School of Management gives SNC a very high rating amongst Canadian companies.
  • In 2010 corporate responsibility magazine Corporate Knights ranked SNC as the 7th, out of 50, most socially responsible businesses in Canada, though Larry Macdonald of Canadian Business asks whether that should still be so.
  • Noted corporate ethics activist and major SNC shareholder (and formerly a Board member) Stephen Jarislowsky expresses confidence in SNC in this French language article and tells the reality of doing business in countries where corruption is endemic.
Business Repercussions?
  • Possible reputation loss or even outright debarring from contracts is discussed in general terms by the World Bank's anti-bribery Integrity Vice President in this Globe and Mail piece. World Bank contracts are a small part of SNC revenue.
  • Total revenue from Libya in 2010 when operations were at full bore, came to $418 million, or 6% of SNC's revenues per the Management Discussion and Analysis.
Stock Opinions
  • Post price fall, the average rating of eleven stock analysts for SNC is 2.27, a weak buy, according to TMX whereas before the fall, the rating was 1.17, a strong buy. As of March 9th, three analysts rate SNC a strong buy, two as a moderate buy and six as a hold. Yahoo Finance (using Thomson/First Call as source) shows SNC rated strong buy by six analysts, buy by seven and hold by two. Yahoo's ratings are more or less the same after as before the fateful press release. There are no sell ratings among them.
  • TMX shows an analyst average 12-month price target of $52.20 while Yahoo's is $50.87.
  • A National Bank analyst is quoted in the Globe and Mail as recommending not to buy at the current price, though he sets a price target of $45, which is well above the current $39 or so price. A BMO Capital Markets report, available only through BMO Investorline, goes through a valuation to arrive at a $40 price value for SNC stock. More analyst speculation is in this CBC News March 1st posting.
  • Bond rating agency DBRS put SNC credit rating of BBB (high) under review while waiting for developments. Its reason is that "these latest developments could indicate possible deficiencies in the Company’s risk management and project control systems". The rating could be revised downward "in the event that the currently identified issues indicate more widespread problems in SNC’s risk management systems or business model, which could cause material damage to the Company’s capability to acquire, manage or execute on new projects".
  • Short interest on SNC is impossible to obtain online without subscribing to a paid subscription service but the stock does not appear in the latest February 29th list issued by TMX (day after press release) of the twenty most heavily shorted stocks on the TSX. Short sellers aren't betting heavily against SNC.
How does this all add up? A one-off problem with a few people going beyond the rules for a limited number of transactions in Libya who got caught early enough because one employee abided by the company's ethics code and blew the whistle? In this case, the stock troubles are temporary and there is a buying opportunity. Or is it a wider problem that indicates serious future trouble for the company and for investors, where the path leads downwards to further losses? For now, on the balance of probabilities, this shareholder is not selling.

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, 2 March 2012

Fixed Income: Which is "best" - GIC, Individual Bonds, Target Maturity ETF or Traditional ETF?

GICs and individual corporate bonds have been around forever. Broad-based corporate bond / fixed income ETFs (we'll call them "traditional" ETFs in this post) have existed for a decade or more too. In the last couple of years, BMO, then RBC, launched a series of target maturity corporate bond ETFs to add to the mix available to online investors. So today we ask ourselves - How do they compare, is there one "best investment" or if not, what does each do best? We'll take real examples to assess the current situation.

The Contenders
As usual we have compiled a comparison table below using current data for the following investments:

"Best" is relative to investment objectives
1) GIC - Looks to be the winner by a slight margin for any kind of near-term spending goals requiring a large lump sum of money at predictable or planned moment for which capital preservation is key. Examples might include funding post-secondary education in an RESP, a house purchase in a TFSA or RRSP. A GIC is a highly predictable and simple investment. If held to maturity, the interest rate is the yield and it never varies. The investor's return is exactly the interest rate and it will not change, no matter whether interest rates in the economy go up or down. The compounding option allows cash to be reinvested at the same rate and not sit idle. The GIC is a winner because the rates on offer now are at least as or better than the other investment options when true net yields are calculated (see Net Yield line highlighted in pale yellow in the table).

Another possible use is to set up a sequence or ladder of GICs staggered at whatever maturity intervals desired to hold cash securely in preparation for annual withdrawals from a RRIF to fund retirement spending.

A practical drawback is that not all issuers are available at all brokers and the highest rates may not be available through your broker. For example, Outlook is not listed at this blogger's broker. The highest available five-year rate is only 2.75%. GICs also lack some flexibility since the cashable variety incur a big interest penalty, more or less negating the value of making the investment at all. They are not a good emergency fund.

Nor do they lend themselves easily to maintaining a target asset allocation within a portfolio. Selling to reduce an allocation occasions the interest penalty. Buying to add to an allocation cannot go through existing GICs; new ones must be bought and one might end up with too many small GICs after some years.

2) Individual Bonds - Bonds lend themselves well to creation of a ladder, usually done with maturities about a year apart. The ladder could be used to similar fixed funding objectives as GICs e.g. annual retirement spending with each bond's cash used as it matures. Once the bond is purchased, just as for GICs, if held to maturity, the YTM/return and cash flows are fixed and precisely known. There is no variation. The certainty can help for planning. As our Bell Canada bond example shows, Net Yields now for middle range investment grade bonds are about the same as the best GIC rates.

The biggest drawback of bonds is the exposure to a much more limited number of companies than in a fund. Ten individual bonds in a ten year ladder is not many. A company that is rated investment grade today may not be so in a few years (readers may wish to read more about such realities in our post on default risk). Another practical challenge of bonds is that different brokers also have more or less bond inventory to sell, so a desired maturity date, credit rating, premium/discount, coupon etc may not be available as required.

Should an investor sell before maturity, the price will be influenced by the change in interest rates since purchase. If rates have gone up, the bond's price will be pushed down, probably the more likely scenario today looking forward given the historically low rates in the market. If rates were to go down, then a bond's price will rise. There is a limit that as bond gets approaches maturity, its price will gradually converge to the par value of $1000, which is the amount the issuing company will pay back e.g. Bell's quoted price today of $1088.05 will give the investor $1000 on March 16, 2018 (along with the final interest payment of course).

Individual bonds are poor for maintaining asset allocation in a portfolio. First, there is a large embedded (in the broker's bid price to buy from you) cost of up to 1%. Second, it will be necessary to pick which of the ladder steps to buy or sell, creating an imbalance.

3) Traditional Bond ETF - The broad-based bond ETFs, such as our example XCB, which maintain a wide variety of bond issuers and maturities, do best for the asset allocation function of portfolio management. Rebalancing is easy, requiring only one trade in any desired dollar amount. When the investment time horizon is unknown or indefinite, the traditional bond fund's indefinite end point makes sense.

The biggest disadvantage is uncertainty, both about eventual returns and distribution cash flows (see explanation below). The big swings in returns that are possible can be seen in the wildly gyrating iShares XCB Performance numbers. The YTM of 3.05% on the iShares website must also be reduced by the annual MER of 0.42% to arrive at the net current YTM of 2.63%. Cash flows also change quite a bit year to year as seen in XCB's distributions.

4) Target Maturity ETF - RQF and its sister ETFs with the range of maturities from one to eight years provide a good compromise product for the objective of lump sum spending at specific time intervals. The promised YTM and return at time of purchase will be very close to the eventual actual return. The hard maturity date for the ETF ensures this for the investor despite small variations due to additions or deletions to the list of bonds in the index it aims to track. One thing that does not change the investor's YTM, very unlike the traditional bond ETF, is interest rate changes. Why this is so is explained in this Seeking Alpha article by Matthew J. Patterson. The mix of interest payments and capital gain/loss may change but the total return does not.

The diversity of issuers - 25 in total in RQF - reduces the risk of individual bond holdings mentioned above, a big plus over individual bonds. Interestingly, that diversity includes provincial government bonds.

Maintaining an asset allocation is easier than with GICs and individual bonds since the ETF can be traded in any amount, though not as easy as the single broad ETF since there would be multiple ETFs in a ladder.

Coupon Yield is not Yield to Maturity nor Ultimate Return
It is important to note, since it often is misunderstood, that the cash interest that gets paid out, the coupon yield, is not necessarily the return that the investor can anticipate achieving. Canadian Couch Potato explains well this crucial difference here. These days with many bonds Premium-priced, the usual reality is that coupon yield is much greater than yield to maturity. Our table shows the expected capital decline, if any, for each investment.

The second reality is that the yield to maturity does not necessarily correspond to what the investor will actually receive as a return in the case of traditional ETFs. The fund never matures - it is perpetually selling bonds when their maturity date approaches to under a year and buying other bonds to maintain something called duration. As the ETF manager alters the portfolio make up to achieve their target duration, there will be an impact on the YTM. What that impact will be is hard to determine, as it depends on the direction and magnitude of the shift, slope of the yield curve and the level of prevailing interest rates.

Translated, this is what it means for our example investments:
  • GIC: Coupon 3.2% = YTM 3.2% = Return 3.2%
  • Individual Bell Canada bond: Coupon 4.4% > YTM 2.8% = Return 2.8%
  • Traditional XCB ETF: Coupon 4.6% > Current YTM 2.63% ? Return ?%
  • Target Maturity RQF ETF: Coupon 5.39% > YTM 2.77% approx.= Return 2.77%
Other ETFs - The ETFs we have picked for our examples are not the only ones in those categories.

Target Maturity ETFs
  • BMO Financial Group - 4 target maturity dates - 2013, 2015, 2020, 2025
  • RBC Global Asset Management - 8 target maturity dates - 2013 to 2020
Traditional Corporate Bond ETFs
  • Claymore Canada - 1-5 Year and 1-10 Year
  • BMO Financial Group - Short, Mid, Long
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.