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TANSTAAFL (There Ain't No Such Thing As A Free Lunch)

    - R.A. Heinlein, The Moon is a Harsh Mistress.

Cost Control

Costs Matter

   An important precept to bear in mind when designing an investment portfolio is, to quote Jack Bogle, that costs matter.  Most mutual funds sold in Canada have management fees - "Management Expense Ratios", or MERs - of 1-3%.  The funds' trading costs, bid-ask spreads on the entities bought and sold, and taxes distributed to unit holders as a result of stock sales will all add to this cost burden.  As was discussed in the section on risk control, it is likely that returns going forward will only be around 4-5%, after inflation.  In this environment, investors can not afford high mutual fund management fees.  Instead, they must opt for low-cost alternatives.  These include: low-cost index funds; Exchange-Traded Funds (ETFs), which are baskets of stocks that can be bought and sold as if they are single stocks and which have very low MERs; and direct ownership of individual stocks, bonds, or trusts.  Although some mutual funds may be necessary in areas where there is no low-cost ETF or index fund, a well-diversified, cost-efficient portfolio can be built with an effective MER of as low as a few tenths of a percent.  The cost savings amount to thousands of dollars a year on a moderately-sized portfolio.

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Active Management and Costs

   In 1991 Nobel-prize-winning economist William Sharpe published a paper entitled "The Arithmetic of Active Management".  Using simple assumptions and elementary arithmetic, the paper showed that, if a securities market has a low-cost index fund available, active managers as a group will underperform indexers by the cost differential between active management and indexing.  This analysis does not preclude outperformance by individual managers, only outperformance by the set of all active managers.  There is no Lake Wobegon in which everybody is above average.  Sharpe's analysis does not depend on market efficiency, but only on the cost differential between active and passive management.

  The analysis does not apply to all securities markets because not all markets have index funds available.  Individual housing and private business holdings are an important exception.  However, Sharpe's arithmetic is applicable to essentially the entire U.S. stock and bond markets; most of the Canadian stock market except for small- and micro-capitalization stocks and most income trusts; the entire Canadian bond market; and large-capitalization stocks in the stock markets of most of the developed world.  It therefore applies to a significant part of most investor's portfolios, and to all of some investor's portfolios.  It follows that investors should only utilize active management in markets in which they are sure they, or the managers they choose, have an edge

  One of the consequences of Sharpe's arithmetic is that outperformers must succeed at the expense of underperformers.  To quote Sir John Templeton again, "It's a contest".  If you don't have an edge (or aren't sure that your manager does), the most cost-effective decision is to use passive, not active, management.

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Tax-Efficient Asset Allocation

   Investors must also be concerned about the effect of taxes on their portfolios, since the "tax drag" can amount to 1-2% a year if the portfolio is not properly designed.  The following points should be kept in mind for a tax-efficient portfolio:

  1. Canadian dividend income is taxed preferentially outside an RRSP because of the dividend tax credit.
  2. Capital gains are taxed preferentially outside an RRSP because of the 50% inclusion rate.
  3. Interest income from bonds, debentures, or other entities is taxed at the full marginal rate.
  4. Stripped bonds or Real Return Bonds should not be held outside an RRSP because imputed income will be taxed.
  5.  Real estate trusts and many income trusts include large a return-of-capital component that is tax-deferred outside of an RRSP.
  6. Some income trusts have a small tax-deferred component and should be held inside an RRSP.
  7. A trust or "preferred security" (Canadian Originated Preferred Securities, or COPRs) producing entirely interest income, should usually be kept inside an RRSP.
  8. U.S.-source dividends are fully taxable when held outside an RRSP and will  be subject to a 15% withholding taxa.  (A tax credit will be given when the tax return is filed.)
  9. According to Article 10, Paragraph 1, of the U.S.-Canada tax treaty, U.S.-source dividends are not subject to tax when held in an RRSP.

   a.  If the US investment is held through an American broker, form W-8BEN must be filed with the brokerage to avoid a 30% tax withholding rate.  If a Canadian broker is used, form W-8BEN is often requested for new accounts.

   Income-producing investments should be placed within a Registered Retirement Savings Plan (RRSP) during asset accumulation.  Bonds should be placed in an RRSP first.  If there is room left, high-income equities should then follow.  Low-income equities can be left outside the RRSP with minimal tax consequences.  Cash can be divided between RRSP and non-registered portfolios.

   Because of the tax laws, a major factor in establishing a tax-efficient asset mix for an income-seeking investor is the relative size of the registered and non-registered portfolios.  With a large non-registered portfolio, the income-seeking investor may hold a significant portion of the portfolio in preferred shares (which should always be in the non-registered portfolio) because insufficient RRSP room is available to shelter bonds.  On the other hand, if the non-registered portfolio is quite small, the investor may hold no preferred shares.

   Tax-efficient asset allocation of Canadian assets should be in accordance with the following table:

Tax-Efficient Asset Allocation

Asset Class Non-Registered Registered
Canadian Stocks or ETFs Usually Best OK
Canadian Preferred Sharesa Yes No
COPRsa If necessary Yes
Tax-Deferred Canadian REITs/Trustsb Yes If necessary (e.g. for RRIF)
Income Trusts with Low Tax Deferralb If necessary Yes
Canadian Stripped Bond No Yes
Canadian Normal Bond If necessary Yes
Canadian Real Return Bond No Yes
US/Foreign Equity (high-dividend, low-growth) If necessary Yes 
US/Foreign Equity (low-dividend, high-growth) Usually best OK 
US/Foreign Normal Bond If necessary Yes
US/Foreign Stripped Bond No Yes
US TIPS Bond No Yes
  1. Preferred shares produce dividend income and should be held outside an RRSP.  The entities called "Canadian Originated Preferred Securities", or COPRs, produce interest income and should usually be held inside an RRSP.
  2. Most REITs or trusts include a "return of capital" component that is tax-deferred outside an RRSP.  If the trust produces entirely interest income, it should be held inside an RRSP.  The tax status can be determined from the trust's web site.
   To examine how to implement a tax-efficient asset allocation policy, let us consider a series of examples based on the FPX Balanced Index and various registered - to - non-registered ratios.  Preferred shares will be used to replace the bond content in the non-registered portion.  The ETFs XSP and XIN have already been explained; SPY and EFA refer to the stock symbols of U.S.-traded ETFs tracking the S&P 500 and EAFE indexes. 

   Note: The use of the FPX Balanced Index in these examples is arbitrary, and for illustrative purposes only.  Other sample portfolios with greater diversification are shown in the section on portfolio construction.

FPX Balanced - $100,000 Total Investment

Registered: Non-Registered 75:25

  Registered Non-Registered
S&P/TSX 60   $25000
S&P 500 XSP or SPY: $10000  
EAFE XIN or EFA: $15000  
Bonds $40000  
Cash $10000  

Registered: Non-Registered 50:50

  Registered Non-Registered
S&P/TSX 60   $25000
S&P 500   XSP or SPY: $10000
EAFE   XIN or EFA: $15000
Bonds $40000  
Cash $10000  

Registered: Non-Registered 25:75

  Registered Non-Registered
S&P/TSX 60   $25000
S&P 500   XSP or SPY: $10000
EAFE   XIN or EFA: $15000
Bonds $25000  
Preferreds   $15000
Cash   $10000

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Tax Loss Harvesting

   Tax-loss harvesting is a method of utilizing tax losses to minimize - or defer - capital gains taxes in the non-registered investment account.  It can be useful both during asset accumulation and during withdrawal phases.  

   In order to harvest tax losses, a security in the non-registered account is sold at a time when its price is significantly below its adjusted cost base [i.e. the purchase price plus any commissions or reinvested dividends].  The security is then replaced in the non-registered account by a similar, but not identical, security.  After thirty days, the original security can be repurchased, if desired.  The previously-available strategy of immediately repurchasing the sold security in an RRSP no longer results in an allowable loss.

Example 1:  Tom has a U.S. total-market index fund based on the Wilshire 5000 Index, which is in a loss position.  He can harvest the loss by selling the fund and replacing it with a similar, but not identical, fund based on a different index.  In this case, an appropriate replacement would be based on the Russell 3000 Index.

    CRA may disallow the loss if one index fund is replaced by an identical index fund from a different vendor. Replacing the fund by one tracking a similar, but different, index avoids the problem.  The harvested loss can be used to reduce capital gains taxes in the current year.  If no capital gains taxes are due in the current year, the loss can be carried backwards three years or forwards indefinitely.

Example 2:  Tom has a Europe-Australasia-Far East (EAFE) fund which is in a loss position.  Tom can harvest the loss by selling the EAFE fund and dividing the proceeds in a 3:1 ratio between separate Europe and Asia-Far East components.  After 30 days, the separate components can be sold and the EAFE fund repurchased. 

   A similar approach can also be used with individual securities, such as replacing one bank stock by the stock of a similar bank at a time when all bank stocks are under pressure, or by replacing one oil-and-gas trust by a similar one when oil prices are low.

    Note that these approaches defer tax, but do not avoid it.  They are appropriate when the tax is deferred until several years in the future or when the technique moves taxable capital gains into a lower tax bracket.

   Further examples of this approach will be given in the section on Withdrawal Strategy.

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Payback Time

   In order to determine which of several alternate approaches is the most cost effective, it is useful to calculate the payback time associated with a certain move.  This entails calculating both the initial cost and then the cost savings per year.  The payback timea is how long it would take for projected cost savings to recover the initial expenses.

Example 1: Tom has $20000 of his non-registered portfolio in a U.S. equity mutual fund with an expense ratio of 2% per year. He is considering replacing it with a similar ETF with an expense ratio of 0.15%.  He will not incur any service charges by redeeming the fund, but will have to pay capital gains taxes of $500.  He will also have to pay brokerage fees and foreign exchange.

Estimating the foreign exchange penalty as 1%, the cost of making the switch will be: $500 tax plus  $40 brokerage fees plus $200 foreign exchange, or $740.  The mutual fund costs $400 a year in expenses.  The ETF will cost 0.0015*($20000-$740), or $29.  The cost savings are $400-$29, or $371 per year.  The payback time is $740/$371, or two years.  If Tom's time horizon for holding this equity is more than two years, he should make the switch.  On the other hand, if the capital gain was quite large, the payback time would be very long and it would not be worthwhile making the switch.

Example 2: Geraldine wishes to invest $10000 Canadian in a U.S. index fund. She is considering the TD US Index e-fund, which tracks the S&P 500 and has an MER of 0.33%, and the Vanguard VTI ETF, which tracks the Wilshire 5000 and has an MER of 0.07%.

The TD e-fund will cost $33 per year and will not incur either brokerage fees or foreign exchange.  The VTI purchase will cost only $7 Canadian per year in expenses, but will incur a foreign exchange penalty of about $100 and brokerage fees of about $35.  The payback time is ($100+$35)/($33-$7) or over five years, not including the effect of additional foreign exchange charges on any distributions from VTI.  (Geraldine may have other reasons for choosing VTI, perhaps because she wishes exposure to the entire U.S. market instead of the S&P 500 or if she has a brokerage account at another institution than TD.)

   Similar calculations can be made to determine the minimum amount to invest in a certain approach for a given payback time.

Example 3: Tom is considering in investing in the BGI iShares Financial ETF, which has an MER of 0.55%.  On checking the ETF holdings, he notes that seven companies (the five big banks, Manulife, and Sun Life) account for over 75% of the holdings.  If he also adds Power Corporation at above its market weightb to include its holdings in subsidiaries Power Financial, Great West Life, and Industrial Group, he can replicate over 80% of the ETF.  If Tom pays $26 at a discount broker, how much money does he need to invest in all eight stocks to break even in one year?

The total cost of buying eight stocks is 8*$26, or $208.  The cost of buying the ETF is $26, so the extra cost is $182.  The investment required to recover this cost in one year is $182/0.0055 or $33K. 

Investors considering this approach should be comfortable with the prospect of monitoring individual securities.

  1. Although the simple or undiscounted payback time is used here, more sophisticated users may wish to calculate a "discounted" payback time that takes into account the time value of money.
  2. Risk tolerance can be improved by equally-weighting rather than market-weighting the individual stocks, although the stock mix will track the underlying index less closely.

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