First of all, when we say an ETF is Canadian, we’re not referring to the investments it holds. For example, a Canadian ETF might hold U.S. or foreign stocks. Canadian ETFs trade in Canadian dollars and are sold in Canada. Similarly, U.S. ETFs trade in U.S. dollars and are sold in the U.S. Canadians can buy U.S. ETFs through Canadian discount brokers but must trade them in U.S. dollars.
Vanguard Canada offers “asset allocation ETFs” that simplify investing greatly. One such ETF has the ticker VEQT. This ETF holds a mix of Canadian, U.S., and foreign stocks in fixed percentages, and Vanguard handles the rebalancing within VEQT to maintain these fixed percentages. An investor who likes this mix of global stocks could buy VEQT for his or her entire portfolio without having to worry about currency exchanges. It’s hard to imagine a simpler approach to investing.
Investors who prefer to own bonds as well as stocks can choose another asset-allocation ETFs offered by Vanguard Canada, BlackRock Canada, or BMO. But the idea remains the same: we own just the one ETF across our entire portfolios. For the rest of this article we’ll focus on VEQT, but the ideas can be used for any other asset-allocation ETF.
Why would anyone want to own a set of U.S. ETFs instead of just holding VEQT? Cost. It’s more work to own U.S. ETFs and trade them in U.S. dollars, but their costs are much lower. To see how much lower, we need to find a mix of U.S. ETFs that closely approximates the investments within VEQT. Readers not interested in the gory details of finding this mix of U.S. ETFs can skip the end of the upcoming subsection.
VEQT Breakdown
Inside VEQT is a set of other Vanguard Canada ETFs. As of the end of 2018, here was the breakdown:
- 39.7% VUN (U.S. stocks)
- 30.1% VCN (Canadian stocks)
- 22.8% VIU (foreign stocks in the developed world)
- 7.4% VEE (emerging market stocks)
Digging into each of these ETFs, we find that VUN just holds the U.S. ETF VTI, and VEE just holds the U.S. ETF VWO. Things are a little more complicated for VIU. The U.S. ETF VEA is very similar to VIU, except that VEA is 8.7% Canadian stocks. So, we can think of VEA as 91.3% VIU and 8.7% VCN.
Sparing readers further calculation details, here is a mix of ETFs with the same holdings as VEQT:
- 27.9% VCN (Canadian ETF holding Canadian stocks)
- 39.7% VTI (U.S. ETF holding U.S. stocks)
- 25.0% VEA (U.S. ETF holding non-U.S. stocks in the developed world)
- 7.4% VWO (U.S. ETF holding emerging market stocks)
Cost Difference
To decide whether to go with a very simple portfolio of just VEQT or the more complex mix of 4 ETFs, we need to know how much money the more complex approach saves. There are four main factors to consider in this cost comparison: management expense ratio (MER), unrecoverable foreign withholding taxes (FWT) on dividends, trading costs, and currency conversion costs.
Foreign withholding taxes on dividends are likely the least familiar cost for most investors. When we own U.S. or foreign stocks, the U.S. or foreign country may withhold a percentage of dividends which we may or may not get credit for when we file our taxes in Canada. This area can get complex. Fortunately, Justin Bender has a very handy Foreign Withholding Tax calculator that provides most of this information as of the end of 2018.
For VEQT, MER+FWT is 0.495% when held in a TFSA or RRSP, or 0.271% when held in a taxable account. Why the difference? When we file our income taxes, we get credit for paying dividend taxes to a foreign government if the investment is in a taxable account, but we don’t get this credit in a TFSA or RRSP.
For the mix of VCN and the 3 U.S. ETFs, the blended MER+FWT depends on what type of accounts hold the various ETFs. If we keep the U.S. ETFs out of our TFSAs, the blended MER+FWT is 0.132%. This is much cheaper than VEQT for two main reasons. The first is that the MERs of U.S. ETFs are lower than those of Canadian ETFs. The second relates to tax treaties between Canada and the U.S. When Canadians hold U.S. investments in an RRSP, the U.S. does not impose withholding taxes on dividends. However, when we own VEQT in an RRSP, there is an extra layer of ownership and we get charged the U.S. taxes on dividends.
For an investor who has no investments in taxable accounts, the difference in MER+FWT between VEQT and the mix of 4 ETFs is 0.36% per year. However, owning 4 ETFs, 3 of which trade in U.S. dollars leads to currency conversion costs and higher trading costs (when adding new money, rebalancing, and when withdrawing in retirement). Assuming an investor who uses Norbert’s Gambit to keep currency conversion costs down, the extra trading and currency conversion could easily cost $200 per year. This makes the 4-ETF approach cheaper than owning just VEQT by $200 less than 0.36% of the portfolio size.
For an investor with a $50,000 portfolio, owning just VEQT is actually cheaper by $20 per year. At $100,000, the annual savings of owning the mix of 4 ETFs is $160, hardly enough to be worth the added trouble. However, an investor with a million dollar portfolio would save $3400 per year with the 4-ETF approach.
Some might be tempted to say that once you’re a millionaire, why worry about a lousy $3400 per year? Well, if we assume a 4% withdrawal rate at the start of retirement, that million dollars gives only $3300 to spend each month. Sticking with VEQT would cost a full month’s spending every year.
A Compromise
It seems that if we want to avoid wasting a big chunk of our available spending in retirement, we have little choice but to own some U.S. ETFs and handle all the extra trading, rebalancing, and currency conversions. However, there is a compromise.
Why not just start with only VEQT and worry about splitting into 4 ETFs later? For young investors starting from nothing, it could take years to get to a portfolio of, say, $200,000 when the cost savings of the 4-ETF approach start to become worth the trouble.
Even after we sell all the VEQT to buy VCN, VTI, VEA, and VWO, we could still buy VEQT with any new money we add in the future. We could limit the trouble of dealing with 4 ETFs to very infrequent mass switches of $200,000 or more.
Although world stocks tend to move up and down together, it’s possible that our 4 ETFs could get out of balance once in a while. In most cases, it would be possible to rebalance without any currency conversions. We could adjust the level of VCN by trading between VEQT and VCN. We could adjust the levels of the 3 U.S. ETFs by trading among them using just U.S. dollars.
Conclusion
Whether to go with the simplicity of an asset allocation ETF or the lower cost of U.S. ETFs doesn’t have to be an all-or-nothing decision. A careful compromise of waiting until the total amount of VEQT reaches a chosen threshold can get us most of the simplicity along with most of the cost savings.
Other considerations that come to mind:
ReplyDeleteIf more than 60k USD in US-situated assets (i.e., US ETFs) are held at death, the IRS will want an estate tax return to be filed, even though likely no tax for a Canadian will be owed unless the estate is valued at over 11M USD. But they will want their paperwork regardless.
T1135 reporting requirements kick in for foreign assets over 100k CAD (not held in an RRSP or TFSA).
Cost base tracking and capital gain (or loss) reporting for the relevant securities in a taxable account when using Norbert's gambit.
Might still be a worthwhile venture for some, but people need to go in with their eyes open.
@Anonymous: It's true that things become more complex when you have significant assets in taxable accounts. That's why I have my U.S. ETFs in RRSPs and I use VEQT in taxable accounts. It's possible to make reasonable trade-offs for portfolios well into the millions without many of the troubles you describe.
DeleteI get the simplicity of buying VEQT as you gradually add to a non-registered account. However, once a certain sum is established, say 30k$, wouldn't it be more cost effective to rebalance in order to have that 30k$ in VCN to take advantage of the dividend tax credit (and adjust the registered accounts accordingly to attain allocation %). You would then continue buying VEQT with your new contributions, until the targeted lump sum is achieved again. If you're maximizing, as you are, the location of ETFs (VTI in RRSP, XEF in TFSA) wouldn't this be the most tax efficient method? Wouldn't add much complexity either.
Delete@Anonymous: If you have so much savings that you've used up your TFSA and RRSP room, then it does make sense to consider the DTC if you choose to split up VEQT into 4 separate ETFs. I limited my analysis here to portfolios of TFSAs and RRSPs.
DeleteIf you're suggesting that it makes sense to put VCN into a taxable account even if you have available room in a TFSA or RRSP, I've never seen a plausible scenario where this makes sense. It's true that the DTC makes the effective tax rate negative when your income is below about $47k, but you'll ultimately have to include some capital gains in your income. The tax-free growth of TFSAs and RRSPs are hard to beat.
Random questions your article made me think of:
ReplyDeleteSo why isn't there a VTI.TO rather than a VUN?
The W8-BEN is only a 'at source' thing, correct? Meaning the 'foreign tax paid' rebate/refund should cover not having filled it out?
@aB: I'm no expert on either question. It would certainly be convenient if VTI traded in Canada in Canadian dollars as well as in the U.S. in U.S. dollars the way Royal Bank and many other stocks do. There must be a good reason, but I don't know what it is.
DeleteAs for the W8-BEN, my understanding is that this form gives you access to the tax treaty with the U.S. to reduce withholding taxes from 30% to 15%. This is certainly important for TFSAs because you can't deduct the withheld tax. I'm not sure what would happen with a taxable account if you didn't fill out a W8-BEN. You'd have 30% of your dividends withheld, but I don't know if CRA would let you deduct the 30% you paid from your taxes owing for the year.
Micheal: What if I have a $1M portfolio with 40% in a taxable account - 60% registered. Let's say I move everything to VEQT (irrespective of triggered capital gains). As a retiree, close to 70, I would like to have a portion of it in some sort of bond ETF.
ReplyDeleteI'm thinking of having a 60-40 (fixed-equity) mix.
My question is: Would it be interesting to put the 40% equity in VEQT and 60% in something like ZAG, XBB or something similar? VBAL does the opposite (60% equity-40% FI).
@Unknown: If you're looking for simplicity, Vanguard offers an asset allocation ETF that is 60% bonds -- VCNS. You can look at the full range of asset-allocation ETFs that Vanguard Canada offers here:
Deletehttps://www.vanguardcanada.ca/individual/etfs/about-our-asset-allocation-etfs.htm
I haven't done the analysis of how much you could save by buying the constituent ETFs of the asset-allocation ETFs that include bonds, but I'm guessing the savings are smaller. Keep in mind that whatever you decide you have the option to make the changes over time to manage any capital gains you might trigger in your taxable accounts.
Indeed, VCNS might be one solution. Yet what about getting some monthly cash to live on?
DeleteI don't think the yield would be enough to cover about $35K per year (not including CPP/OAS).
Would it mean that every month I would have to sell some shares to get the amount I need?
@Unknown: Selling shares periodically is one solution. If you choose this route, remember that VCNS does produce some dividends and interest, so you'd only have to sell enough to make up the difference. Also, you might choose to sell less frequently than every month.
DeleteThere is no completely safe way to generate 3.5% income every year. The good news is that your target income is in the conservative range for a 70-year old with a million-dollar portfolio.
The following exchange is reproduced to remove broken links.
ReplyDelete----- Unknown July 29, 2019 at 2:33 PM
Hi Michael, great article as I have been looking hard at the issue of taxation as my portfolio grows as a drag on portfolio performance. I was wondering if as a follow up you would be willing to compare costs using a low cost Canadian alternative to the U.S. listed ETF as opposed to comparing to VEQT. For example, VFV (a Canadian ETF that tracks the S&P 500) charges only 8 bps, much lower than the 22 bps charged by VEQT. What would be the break even point for an investor to benefit from owning separate Canadian listed ETF's with all fees and tax withholding considered vs. their U.S. counterparts vs. VEQT? This third option reduces overall expenses but retains most of the simplicity (read: No currency exchanges to manage).
----- Michael James July 29, 2019 at 3:06 PM
@Unknown: If you choose to own the constituent Canadian ETFs of VEQT (VCN, VUN, VIU, and VEE), you save 0.1% on MERs and nothing on foreign withholding taxes at the cost of, say, $100 per year in extra trading. Compared to owning the U.S. ETFs, you pay about 0.26% more in MER+FWT and save about $100 per year in trading. On a million-dollar portfolio, you're paying about $2500/year more vs. $3400/year more with VEQT. Which approach suits you best depends on portfolio size, relative sizes of different account types, and how much you're willing to pay for simplicity.
The following exchange is reproduced to remove broken links.
ReplyDelete----- BHCh July 31, 2019 at 12:16 AM
Using VIU has advantages in terms of withholding taxes over VEA. VEA spares you of US taxes, but not of taxes where the stocks are domiciled.
----- Michael James July 31, 2019 at 7:58 AM
@BHCh: VIU has a big advantage over VEA in a TFSA (0.21%) and a small advantage in a taxable account (0.06%), but the best option is to hold VEA in an RRSP where it has a 0.26% advantage.
----- BHCh August 1, 2019 at 9:36 PM
Right, depends on the room one has. My vehicles are almost exactly like your second option but RRSP is used up by VTI and VBR.