Friday, 21 June 2013

Saving Taxes on Investments at Death

Death is bad enough for the person involved without the potential for taxes on investments to add pain for the inheritors of whatever legacy is left behind. Fortunately there are a few choices that an investor can make in a Will or that an Executor can make after death to minimize the damage of the grim tax reaper. We'll say in advance that the following is meant to give readers an awareness of some worthwhile options. Due to the complexities of tax law inter-acting with the details of individual situations, this is one area of investing where consulting professionals like lawyers and accountants is advisable especially where large sums are at stake. You only die once and there is no second chance to do it right.

The Law: No inheritance tax, capital gains on deemed disposition instead
Canada has no inheritance tax on assets. Instead, tax law dictates that all assets are deemed to have been sold on the day of death at fair market value. As a result, capital gains calculations must be done for the deceased taxpayer and the income reported on the return for the year of death. It's the day of reckoning - no more deferral of capital gains.

In addition, tax-deferred (RRSP, RRIF, LIRA, LRIF etc) and tax-exempt TFSAs of the taxpayer are forced to end and everything is considered to have been withdrawn in the year of death. For example, someone with a $250,000 RRIF balance will have that much income on their year of death final return, putting them into the highest tax bracket. RRSP contributions that years before may have received a refund based on much lower marginal tax rate suddenly are reclaimed at the top marginal rate. Ouch! Considering that a taxpayer may have other assets like a family cottage that has accumulated a large capital gain but which the children do not want to sell to pay the tax, the sudden large tax hit may cause cash flow problems. Big financial worries are not welcome at a time that is already emotionally stressful. What can be done?

Transfer RRSP / registered plan or TFSA to spouse
If there is a surviving spouse (or common law partner or financially dependent children and grandchildren), the deemed disposition of such plans can be avoided by naming the spouse as beneficiary to the plan issuer / administrator (e.g. the online brokerage like BMO InvestorLine etc). The Income Tax Act allows this. The surviving spouse in effect steps into the deceased's shoes and continues on. There is no effect or dependence on the survivor's contribution limits or room. See's Death of a TFSA holder and Canada Revenue Agency's TFSA Guide and Death of an RRSP Annuitant for details. Estate Planning for RRSPs at the CGA website explains some of the mechanics how all this is accomplished and gives an informative example.

An added benefit is that such direct transfers avoid the registered plan assets being taken into the Estate of the deceased and being subject to another tax, the provincial probate fees. In some provinces probate fees/taxes are minimal, while in others like Ontario and Nova Scotia, they can be substantial for larger estates (see tables for each province).

Implement a Spousal Rollover
The law allows the Executor to decide, after death and presuming it is also in accord with provisions of the Will about who inherits pieces of the estate, to rollover assets to the spouse (or the same qualified beneficiaries as above) in order to avoid deemed disposition. The spouse takes over the assets at the same Adjusted Cost Base the deceased had.

The rollover is a more general case of the RRSP rules i.e. it also can apply to non-registered accounts and assets. That can be very beneficial in avoiding a large immediate tax hit if there is a large accumulated unrealized capital gain in an unregistered portfolio. Lawyer John Mill in his Succession [Tax Counsel] blog article Spousal Rollover - the most valuable tax plan? provides more detail on how rollovers work and when there are or are not useful.

One situation where they might not help is if the deceased taxpayer has accumulated capital losses of previous years to offset potential gains from deemed disposition.

The Executor is allowed to decide to rollover, which is the default, or opt out of it. Deciding exactly what to do can get quite involved as the rollover is allowed on a property by property basis (see Tax Specialist Group's Electing Out of a Spousal Rollover on Death) e.g. one stock with no unrealized gain might not be rolled over while another with a large gain might be to avoid triggering immediate tax in the final return. When a Will divides an Estate amongst a spouse and children for example, the spouse could receive assets with gains to rollover while children get assets with no unrealized gains. If the deceased taxpayer pays less, everyone gets more. However, if the Will gets too specific about who gets what assets, that may not be possible - a Will drafted with good professional tax advice and properly written with good legal advice becomes ever more important the more investments there are and the more complicated the situation.

Consider a post-death contribution to a spousal RRSP
To obtain a RRSP deduction and reduce taxable income in the year of death on the final return of the deceased taxpayer, the Executor can make a contribution to a spousal RRSP within 60 days of the date of death. Death and Taxes in the CGA magazine discusses this option amongst others.

Set up a Testamentary Trust(s) in the Will
Testamentary Trusts, most commonly created by a Will, begin when a person dies. They hold assets on behalf of one or more beneficiaries. The key benefit is that they are treated as a separate taxpayer under tax law. That means that income splitting between spouses can continue. The trust is taxed at graduated rates just like an individual. Two income streams, one from the trust containing the deceased taxpayer's assets and one from the surviving spouse can each pay at a lower rate than the combined larger income would. Properly written, the Trustee (often set up to be the surviving spouse) can decide whether and how much of the income to have taxed in the Trust or to be distributed to the beneficiary for taxation in his/her hands year by year. RRSP money can go into a Testamentary Trust.

The biggest limitation is that the Trust is not allowed to distribute capital losses to the beneficiary. Losses can only be used to offset capital gains within the Trust. Capital gains on the other hand, may be distributed to the beneficiary.

There's another benefit. Rollover rules apply, so assets can be rolled over into a Spousal Testamentary Trust, avoiding deemed disposition and deferring the realization and taxation of capital gains.

Though a non-Spousal Testamentary Trust, e.g. a Testamentary Trust for non-financially dependent children, cannot benefit from rollover, it can still provide income-splitting tax advantages for them. A high-earning top tax bracket adult child might benefit from receiving an inheritance from a parent not directly but indirectly in a Trust, which they could control if named as trustee with full discretion, since the income could be taxed in the Trust at a lower rate. See McEwan & Co Law Corp's Estate Planning page for more detail on ins and outs of Testamentary Trusts in amongst other topics.

A separate account to manage a Testamentary Trust can be set up at most online brokers. It should also not add much to lawyer's fees for writing a Will.

Check out the possible tax benefit of carryback of Capital Losses
Special unique tax rules apply upon and just after death, when the deceased's investments pass temporarily into the Estate, pending distribution to the people named in the Will. The Estate is a separate taxpayer from the deceased person and from the subsequent inheritors or Trusts such as those discussed above. In fact, the Estate itself is a Trust.

After death, the financial world doesn't stop. Interest on bonds is received, dividends too. When the Executor takes control after the Will has been approved by a court through probate (cautious financial institutions won't let Executors trade until probate is done) there may be buying and selling of securities within the Estate. Normally, as a separate taxpayer the Estate would have to compute and report its own taxes. The special rules of Subsection 164(6) allow the Executor to carryback capital losses in the Estate, incurred up to a year after death, to the final return of the deceased taxpayer.

Another special rule allows capital losses, normally deductible only against capital gains, incurred during the year up to the date of death to be deducted against any type of income in the final return and in the return of the year preceding death (which if already filed would be done with an adjustment form - see CRA's T-4011 Preparing Returns for Deceased Persons 2012 and the T-4013 T3 Trust Guide). However, the Estate carryback can only be applied to the final return, not also to the preceding year.

As we said at the outset, if you are not already convinced of the usefulness of professional advice when it comes to carrying out these strategies, please consider it. The words of Albert Einstein, one of history's most brilliant thinkers, merit reflection: "The hardest thing in the world to understand is the income tax." That he said this talking to his accountant shows he was also smart enough to know the limits of his own skills.

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, 14 June 2013

Building Your Own Index ETF

Ever thought of building and managing your own equity portfolio using ETF-like index methods? Let's explore how much time, trouble and cost it takes.

The Basic TSX Composite
The TMX Money website lists all the 237 constituents of the TSX Composite Index but not the proportion of each stock, which is needed to know how much of each to buy, so we must turn to BMO, which offers an ETF that tracks the index. Well, almost. The BMO offering traded under symbol ZCN tracks a version of the Composite Index which caps the maximum holding of each stock at 10% of the total fund. BMO does post the percentage weight allocation of each holding, but not the industry Sector each stock belongs in. iShares Canada has an ETF (symbol: XIC) that tracks the same index and it does post the Sector for each stock.

Our comparison table shows the end result ETF-like portfolio, as well as the workings described below.
(click on image to enlarge)

Challenge #1 - Too many stocks to buy, picking a representative subset
An attempt to buy and hold all 237 stocks is would overwhelm even the most enthusiastic individual investor. We winnow the list down drastically and yet maintain something representative of the index by taking about 10%, or 24, of the stocks, spreading them across the various Sectors.

The principle upon which the Composite Index / ZCN is based is that each stock should be weighted and held in proportion to its total market value of shares, or market cap. We sorted the downloaded ZCN holdings by Sector and market cap and then took 10% of the stocks within each Sector, ensuring that each Sector was represented by at least one holding. For example, there are only four Health Care stocks in ZCN, so we selected one, Valeant Pharmaceutical, which has the largest market cap. As a result of picking more than 10% in small Sectors our final list of stocks expanded a bit to number 26 in total.

Maintaining the proper Sector weight, which is shown on the BMO holdings page for ZCN, required us to ramp up the allocation to each stock, done in proportion to the share each stock occupies in the Sector. That meant, for example, that Magna and Thompson Reuters went from 1.12% and 0.86% weighting respectively in ZCN, to 3.04% and 2.33% in our home-made ETF to keep the Consumer Discretionary Sector weight total at 5.37%. One of the good and encouraging figures we notice is that the end result 26 stocks make up fully half of the total market value weight out of the 237 original list. It doesn't take many stocks to represent a big chunk of the index.

Challenge #2 - Smaller weight stocks suggest a large amount of capital is required
The next part of our experiment was to estimate how much to buy of each stock. It quickly became apparent that the smaller weight holdings would require low dollar amounts and very few shares. Our example table uses a total portfolio size of $100,000 and even then the smallest holdings are quite puny, like First Quantum Minerals which gets $1269 allocated to it. There would be only 16 shares to buy of Canadian Pacific Railway.

Challenge 3# - Maintenance requires monitoring and trading
The world, and markets, don't stop the day shares are bought. Though the market cap basis of this pseudo-ETF means that values of Sectors will generally stay reasonably in line with the overall index, when non-included companies go up more than the overall Sector, our ETF will go out of whack. In addition, acquisitions and divestitures, mean companies enter or disappear from the index (index creator and maintainer S&P Dow Jones publishes changes as required here). Some trading will be required and expenses incurred.

Testing the feasibility of a novel ETF-like strategy - fundamental weighting of low volatility stocks
Despite the plethora of ETFs, some slants are not yet covered. Inspired by previous blog posts where we wrote about promising alternative index methods like fundamental weighting and low volatility stock selection plus this article - An Investor's Low Volatility Strategy - from Research Affiliates that advocates a combination of the two investment strategies, we decided to put our own home-grown version together.

The idea is to select the least volatile stocks from the fundamental index and to correct the small cap and Sector bias of a typical low volatility index. This is done by ensuring a) the stocks selected are the largest, as measured obviously by the fundamental factors sales, dividends, cash flow and book value (instead of market cap as the TSX Composite does), and b) that the Sector weights of the fundamental index are maintained. There is no such ETF on the market so we have built our own for Canadian stocks and the result is shown below.
(click on image to enlarge)

The PowerShares FTSE RAFI Canadian Fundamental Index ETF (PXC) already selects the largest Canadian companies by fundamental factors. From amongst those we have taken the third (c.29 of 88 stocks) with the lowest volatility,as measured by Beta (figures obtained from the Globe's My WatchList tool where we entered all of PXC's stock stock symbols).

In this portfolio we ended up with 30 stocks after applying the rule to select at least one stock from each industry Sector. Those 30 stocks only represent 35% of the value of the original PXC portfolio, much less than the ZCN-imitator. On the other hand, two companies alone, TD Bank and TransCanada Corp each make up an uncomfortably large 13% of the total portfolio. A mere five of the financial and energy stocks make up half the portfolio, quite a concentrated portfolio. There is a lot more difference in weight than in our first portfolio effort above between between the largest and the smallest holdings. The smallest holdings are really small, much more so than the ZCN-clone.

As both volatility and fundamental weights evolve, there would be a requirement for more monitoring and probably more rebalancing trading. In short, though the paper reveals some very attractive backtested performance results for such a strategy, it does not look very  practical for the individual investor to do him or herself.

Conclusion: For tracking a broad index, building your own ETF-like portfolio isn't worth the time and effort. BMO's ZCN charges 0.15% annually, which would be $150 on a $100,000 holding, ZCN holds the entire portfolio to boot, providing even greater diversification and, BMO does all tracking and rebalancing trading for the investor.

For constructing a portfolio to implement a trading strategy that has index features, it also looks to be impractical. Better to wait for an ETF provider to implement the strategy on a scale that avoids introducing concentration and holding size problems, providing of course that the fees are reasonable.

When it might make sense to build your own ETF-like portfolio - if the index has very few constituents - Specialized ETFs, such as those for individual Sectors, can sometimes be effectively copied with a handful of holdings. For example, the Canadian REIT Sector has only a handful of companies. iShares' REIT offering has 14 holdings, while BMO's has 19. Taking a handful of the main companies may replicate the Sector very effectively. Several years ago, Stingy Investor looked at various Sectors and whether unbundling them, as he termed it, made sense.

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.

Monday, 10 June 2013

Corporate Sustainability (aka SRI/ESG) in Canadian Consumer Stocks

Last November when we first explored the idea of investing according to principles of social responsibility (abbreviated to SRI), often also called Environmental, Social and Governance (ESG) investing, or simply Corporate Sustainability, we focussed on the available SRI/ESG mutual funds and ETFs and used them to look at recent performance of the stocks held in these funds.

Today, we'll return to the topic. A first motive is that those funds are the not final word on which companies merit inclusion. They do not necessarily include all stocks that meet Sustainability principles since the funds attempt to have a mix of holdings across many sectors and thus may neglect worthy companies. Second, there is growing evidence that investors can make money by paying attention to Sustainability. The paper The Added Value of ESG/SRI on Company and Portfolio Levels – What Can We Learn From Research? reviews the literature and finds a positive relationship between company financial performance and the adoption of Sustainable practises. In another paper, The Impact of Corporate Sustainability on Organizational Processes and Performance, Harvard Business School researchers Robert Eccles, Ioannis Ioannou and George Serafeim found that SRI/ESG adopters outperformed both in stock market and accounting terms. Moreover, "The outperformance is stronger in sectors where the customers are individual consumers instead of companies, companies compete on the basis of brands and reputations ...".

Therefore, we will focus on consumer facing companies.

Finding the consumer stocks
Using the free TMX Money stock screener, we selected the Consumer Defensive sector to extract an inital list, cutting it off at companies with $1 billion or more in market cap, to which we added hardware retailer Rona Inc and fast-food vendor Tim Hortons and from which we removed three companies (Saputo, Maple Leaf Foods and Canada Bread) that don't deal directly with consumers.

Getting the "green" info
Unfortunately, and hopefully this will change soon since the data is useful and important to a growing number of individual stock investors, it is not easy to get the data on how much or well companies have implemented Sustainable policies. Bloomberg and Thompson do compile such data and it is available to institutional investors paying the hefty fees but the individual investor is left to troll through corporate documents like the annual report, the management information circular (aka the proxy circular) or presentations freely available on the company Investor Relations website area or on Sedar (under the Search Database tab). So that's what we did and compiled the comparison table below, which we note may not be 100% accurate since some factors are often not very clearly explained - especially the degree to which to which executive compensation is tied to ESG results.

Three key Sustainability factors
The Harvard paper says three indicators explain best the combination of Sustainability adoption and financial success of consumer-facing companies:
  1. Separate Board of Directors committee devoted to Sustainability - If it important enough to the company that the top level policy people are paying attention, it apparently gets done.
  2. Executive compensation tied to Sustainability - If the top managers' pay depends on doing it, then they tend to do it.
  3. Formal stakeholder engagement processes are in place - The existence of mechanisms like surveys, focus groups and audits, to engage with customers, with employees, with the communities where they operate and with suppliers reduces risk and improves adaptability of the companies.
One other factor the study mentions, but which we were unable to compile data for, is that companies succeed better with a bigger proportion of large long term stable institutional investors, as opposed to ones who trade a lot over the short term. This help enable the company to take the long term view to implement Sustainability.

The results - who is green who is not
There are twelve companies in our list:
  • Only three seem to have adopted none of the three key actions - Rona, Alimentation Couche-Tard and Jean Coutu. 
  • None has adopted every single measure either. 
  • All four companies that are held by the iShares Jantzi Social Index Fund (symbol: XEN) - Tim Hortons, Loblaw, Canadian Tire and Shoppers Drug Mart - have adopted at least one of the key measures. It would have been a surprise otherwise.
  • Some companies do appear to be further down the path of making Sustainability an integral part of their business at every level from strategy to daily operations, notably Metro, Tim Hortons, Loblaw, Canadian Tire and Shoppers Drug Mart. Metro, Canadian Tire and Tim Hortons all regularly publish a separate report with multiple metrics on Sustainable activity and performance. 
(click on image to enlarge)

Have the more Sustainably-oriented companies attained higher profitability and stock returns?
Alas, the answer at the moment seems to be No. The company with the best trailing profitability, as seen in Return on Equity and Return on Assets, is the non-SRI/ESG Jean Coutu Group. The company with best five-year compound stock total return is Alimentation Couche Tard, also non-SRI/ESG.

It is encouraging, though we should remember that it may simply reflect the general market trend of what has been a popular sector lately, that all but two of the stocks have given off returns vastly ahead of the overall TSX index, as shown in the table by the iShares S&P/TSX Composite ETF (symbol: XIC).

All in all, the short term results are a reminder of what the researchers found. Adopting Sustainability practices is a long term strategic choice that pays off in the long term and on average. Not every high Sustainability company will do gangbusters, or even necessarily avoid major troubles. Nor will companies that ignore such practises go down the tubes or be financial laggards. The investor needs to undertake normal stock investment assessment as well.

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.