- Investing can be intimidating.
That is one of the reasons that banks have been so good
at convincing their customers to pay high investment fees
for supposed peace of mind.
As the awareness around fees has grown,
more and more people are deciding
to manage their own investments using index ETFs.
Being a DIY ETF investor is not particularly hard,
but up until recently, it was not particularly easy either.
Back in 2017, the simplest portfolio around
was Robb Engen's four-minute portfolio,
which consists of only two ETFs.
If you wanted to reduce your equity exposure,
you would have had to buy a third ETF for bond exposure.
Three ETFs is pretty simple,
but it still requires some thinking for rebalancing
and some discipline to rebalance
into whatever asset class is down at the time.
All of that changed when Vanguard launched
their asset allocation ETFs last year.
I'm Ben Felix, Associate Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you about one-decision funds.
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Let's start off by talking about asset allocation.
At the time of this video being created,
Vanguard has just launched two new one-decision funds
to round out their lineup.
They now have five asset allocations,
ranging from 20% equity and 80% fixed income
all the way up to 100% equity.
This makes the one-decision solution a possibility
for investors at any life stage.
For their part, iShares only has two one-decision funds,
a 60% equity fund and an 80% equity fund.
They came later to the game, so don't be surprised
if they beef up their lineup over time.
Within the stock and bond components,
Vanguard and iShares have made
some slightly different decisions
in putting their portfolios together.
Vanguard allocated 30%
of the Canadian equity portion of their portfolios
to Canadian stocks,
while iShares has gone with
a slightly lighter Canadian allocation of 25%.
With the slightly lower weight in Canadian stocks,
iShares has correspondingly allocated
slightly more to US stocks than Vanguard.
In the long-term, none of this should make
too much of a difference either way.
In both fund families, the currency exposure
has been left unhedged for equities,
and is fully hedged back to Canadian dollars
for fixed income.
Vanguard has chosen
to globally diversify their bond holdings
using currency-hedged global fixed income funds.
Research from Vanguard has shown
that an allocation to currency-hedged global fixed income
can meaningfully improve risk-adjusted returns.
iShares does go outside of Canada
with a portion of their fixed income allocation,
but only as far as the US,
still hedged back to Canadian dollars.
In both cases, the majority of the fixed income
comes from Canadian bonds.
Again, I wouldn't lose too much sleep
over these differences.
iShares has put a little bit more emphasis
on riskier corporate bonds
in their one-decision funds compared to Vanguard.
Vanguard has stuck to total bond market funds,
which are heavier on government bonds.
The credit risk in corporate bonds could pay off long-term,
but it could also lead to more volatility.
Again, the differences here
are not large enough to worry about
or push a decision to invest in one fund or another.
The way that all of these products are structured is great,
from an asset allocation perspective.
It would be be challenging to do any better
by buying the underlying funds on your own,
and the one-decision funds come with
the massive added benefit of built-in rebalancing.
Now let's get to the thing
that everyone seems to be getting hung up on: taxes.
Tax efficiency is extremely important, but so is simplicity.
Let's take a look at how these trade-offs interact
in the case of one-decision funds.
We will start off with foreign withholding tax.
Both iShares and Vanguard were smart
in the way that they structured these funds
to minimize foreign withholding tax issues
to the extent possible for a Canadian-listed ETF.
The only way to make an improvement
would be to get US and international equity exposure
from US-listed ETFs inside of your RRSP account,
the trade-off being that you lose automatic rebalancing,
and you would need to convert your currency.
As an example of this trade-off,
I estimate the unrecoverable foreign withholding tax cost
of VGRO and XGRO
to be about 20 basis points per year in an RRSP.
In a taxable account, there is no way to make an improvement
by splitting up the one-decision funds.
You are no better or worse off from a tax perspective
with the one-decision funds
or with their individual components.
I estimate the unrecoverable foreign withholding tax cost
in a taxable account
to be less than five basis points for both VGRO and XGRO.
It seems that people are afraid
of holding the one-decision funds in their taxable accounts.
Let's be clear. The reason is not withholding tax.
So if we are talking VEQT, the 100% equity Vanguard fund,
there is no issue in a taxable account.
The issue with both the Vanguard
and iShares funds in a taxable account
is that they own premium bonds
in their fixed income allocations.
Premium bonds have coupons
that are higher than their yield to maturity.
This means that your total return
is coming from a combination
of a relatively high interest payment
plus an eventual capital loss.
The problem here is that in a taxable account
you're paying tax on lots of interest,
and then receiving a capital loss,
which cannot be used to offset the interest.
In an RRSP or TFSA, none of this matters.
Your pre- and after-tax returns are the same.
In a taxable account,
your after-tax return on a premium bond
will be lower than it would be on a discount bond or a GIC
with the same yield to maturity.
This is where the fear
of holding these asset allocation ETFs in a taxable account
comes from, and it's a valid fear.
But let's give ourselves some context
before running out to the GIC store.
If we look at a bond with similar characteristics to VAB,
the largest bond holding
in the Vanguard asset allocation ETFs,
it would have an average coupon of 3.21%,
a yield to maturity of 2.63%, and a maturity of 10 years.
When interest rates go down, bond prices go up.
A 10-year bond with a face value of $1,000
and a coupon of 3.21%
would increase in price to $1,050
if bond yields dropped to 2.63%.
If you buy that bond once its price has gone up,
you now own a premium bond.
Before taxes are considered,
you will receive the $32.10 coupon for 10 years.
And then when the bond matures at par, or $1,000,
you will incur a capital loss of $50,
because you paid $1,050 for the bond.
Your total pre-tax return is 2.63%,
which is the yield to maturity on the bond.
So far, so good.
If you instead took your $1,050 and bought a bond
that had just been issued at the current market rate,
so its coupon matches its yield to maturity,
you would receive a lower 2.63% coupon,
and the bond would mature at par at $1,050, no capital loss.
Your total pre-tax return is again 2.63%.
The same would go for a GIC.
Now, adding in taxes is where we see the issue.
After tax, the premium bond results in more taxes owing
because of its higher coupon.
If you have capital gains to offset,
the capital loss does help a bit.
Assuming a 50% tax rate, the after-tax yield will be 1.18%.
The after-tax yield of the par bond would be 1.32%.
That's an annualized difference of 0.14% after tax.
All things considered, that's not so bad,
especially if it's only on, say, 20% of the portfolio,
like it would be in VGRO or XGRO.
We're talking about a few basis points of tax drag.
Even if 40% of the portfolio is in bonds,
we would currently expect less than 10 basis points
in overall tax drag on the portfolio.
Let's also keep in mind that yield to maturity
and average coupon both change over time.
Take a look at the difference
between coupon and yield to maturity
going back to June 2013.
They have been converging as interest rates have come up,
pushing yields higher,
making the premium bond issue less and less of a concern.
This is an issue that will come and go.
If rates continue to rise, it should go away.
Especially if simplicity is the goal,
I do not think that it makes sense
to avoid holding one-decision ETFs in your taxable account
for the sole purpose of avoiding premium bonds.
In terms of asset location,
or trying to optimize which assets go in which account type,
I do not think that there are any guarantees
that it will add value to your after-tax returns.
On top of that, asset allocation gets messy
when you try to optimize your asset location,
because assets in the RRSP need to be reduced
by the expected future tax bill
to arrive at your desired asset allocation.
Confusing, right?
I generally recommend holding the same asset mix
across all account types anyway,
so I do not see a problem with holding a one-decision fund
across all of your account types.
In terms of fees, Vanguard comes in around 0.25% MER,
while iShares is a bit lower at around 0.20%.
In both cases, you're getting very close
to what you could pay
by purchasing the individual ETFs on your own.
The Canadian Coach Potato three-ETF model portfolios
have MERs between 0.12 and 0.16%.
That's pretty close.
When all costs are considered, including MERs,
foreign withholding tax in registered accounts,
and tax drag from premium bonds in taxable accounts,
the one-decision funds are a bit more expensive
and slightly less tax efficient
than slicing up a portfolio of ETFs and GICs.
I think that the added costs and a little bit of tax drag
are easily justified by the simplicity
and automated rebalancing of the one-decision funds,
especially for anyone that values simplicity.
Thanks for watching.
My name is Ben Felix of PWL Capital,
and this is Common Sense Investing.
I'll be talking about
a new common sense investing topic every two weeks,
so subscribe, click the bell for updates.
If you enjoy my Common Sense Investing video series,
don't forget to check out The Rational Reminder Podcast.
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