- 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. (electronic music) 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. (electronic music)
