Saturday, February 2, 2013

ETFs belong in your TSFA

The second strategy that we want to employ in our overall paper securities portfolio (as opposed to your real estate portfolio) is a simple ETF strategy. Our first strategy is the LOW P/E with moderate Dividend yield portfolio. In the 1960s, academic stock market researchers such as Eugene Fama came up with the “Efficient Market” theory. The theory stated that news that impacts company performance specifically and the market in general travels so fast and is evaluated equally fast by knowledgeable investors that it is nearly instantaneously reflected in the market prices. Thus the stock markets are extremely efficient.

As a result, other than by sheer luck, nobody can outperform the markets.  The existence of investors such as George Soros and Warren Buffett were considered aberrations that will overtime revert back to the average market performance. If from that average return investors have to pay commissions and management fees and other expenses to mutual fund managers then it is impossible for the mutual funds to consistently outperform the markets; to the contrary they are likely to underperform. So why would one want to buy an expensive mutual fund or sweat on the research and purchase of individual stocks when just buying the stocks that make up the market index will deliver probably better results? Even better, if you pooled all investment funds and buy the market index, especially smaller investors, would probably get even a discount on brokerage commissions – the Exchange Traded (Index) Funds (ETFs) were born. An early pioneer was John Bogle who created through his fund company Vanguard numerous ETFs. Today, you can buy all manner of ETFs and market index ETFs are quickly outnumbered by those that aim at specific market segments or track specific market strategies.
For small portfolios, market ETFs provide instant diversification at minimal costs. So they are ideal for small and beginning investors. The ease of buying ETFs and the instant creation of diversification with a modest (average market) dividend is also attractive to larger investors in order to build a ‘core portfolio’. For me it is also a way to create very efficiently a portfolio of international stocks in markets with companies that I am not familiar with. Finally it is a tool to create a ‘I am gone fishing’ portfolio, in other words, it does not require a lot of time and work.
But reality remains that markets are not truly efficient – certainly not in the short term. Nearly every day over the last 4 years, the savvy investor could buy shares from great companies for cheap and dirt cheap prices. But in order to do that, you have to be able to determine with significant accuracy what a company is actually worth and how good its management is while buying when everyone else is running for shelter and nobody else wants to touch stock. The theory of buying low and selling high is much more difficult to execute than the simplicity of this statement suggests.
I don’t consider myself the fool-prove stock picker with nerves of steel who can consistently buy stocks as well as Warren Buffett. And even Warren is known to make mistakes. We’re talking genius here! So, an ETF portfolio should be suitable for me. And… I happen to know the ideal place to hold my ETF portfolio: the Tax Free Savings Account or TSFA. There are numerous different views on this account type as well as on its older brother (or sister… maybe I should say ‘sibling’ J) the RRSP.
The reason I prefer a TSFA over an RRSP is straight forward. RRSP only provides you a true investment advantage when you contribute at a lower tax rate than when you withdraw the money. The math is simple: your tax refund is proportional to your current top tax rate. Say you’re making today $30,000 and you your top tax rate is 17%. Your tax refund on a $1000 investment would be $170. So $1000 pre-tax dollars invested at say 10% would after a year provide you with $1100 proceeds. Say your tax rate has gone up that year and you top tax rate is now 38%.  Thus, after that one year you pay upon withdrawal $418 in taxes and your after tax return is: $682
Suppose you do not put your $1000 in pre-tax income in an RRSP. Then you pay $170 in tax first and you have $830 to invest that at 10% returns $83 over which you pay 38% tax upon withdrawal at year’s end or 38% of $83= $31.54 (that is the worst case – i.e. you have pure interest based profits – no capital gains and no dividends). So after tax you have now $830 + 51.46=$881.46
Ehh… what?  I made less in my RRSP? Yep $881.46 outside and $682 inside the RRSP.  Did your investment ‘advisor’ tell you that? Now let’s do the same with a TSFA. You invest $1000 in pre-tax dollars or $830 in after tax dollars in your TSFA for one year at 10%. After one year, you have $830 + $83 = $913 dollars and when you withdraw that… no taxes! You walk away with… $913.  Anyone wants an RRSP?  Anyone expects to make less next year than today? Anyone expects to make less 30 years from now than today?  If you say ‘Yes’ to that last question then why the hell are you investing?
So Godfried LOVESSSSSSSS the TSFA, The only real drawback is that I can only put in $5000… oops $5500 per year. But heck, if you have put in the max contribution since inception you would have contributed $25,500. Not bad considering that that is about the size of the average investment account in the first place! There is one more drawback: When you lose money, you really do lose it – there is no capital loss tax deduction to soften the blow.  But heck we’re long term stock market investors and the chance that you make a loss on a diversified stock portfolio held for 10 years or longer is zilch! Yes if you hold the portfolio for a day or a week your chance to lose money is over 50% but not when you invest for the long term.   In fact, stretched out over decades a stock market index portfolio typically makes 7% plus inflation annually according to research by Jeremy Ziegel (yet another professor).
Now, as a faithful student of stock markets you may have noticed that not all stock markets perform similarly. Often Canada’s TSX underperforms (due to its high emphasis on resource stocks) when the Dow and the S&P500 are on a roll and… vice versa. European markets go their own pace as well. When directly investing in emerging marketsthere is the risk of lower accounting standards, political risk, etc.  This makes these markets more volatile and less desirable for me personally. Canadian resource stocks as well as U.S. large caps often benefit from the growth of these emerging economies as is. Hence, TSX and DOW or S&P500 index funds are good enough and even European large caps will benefit from strong emerging market economies. So why take the risk of investing in them directly?
Now here is another reason I like ETFs… it is called with-holding taxes and Canadian dividend tax credits.  Dividends from Canadian companies get taxed less (by nearly 20%) than interest income and than dividends from international companies. On top of it, when not in a tax shelter such as a RRSP or TSFA you have to pay with-holding taxes (typically 15%) right of the bat. So really, if you hold international stocks you want to hold them in a tax sheltered account. That way you don’t pay tax on your dividends and there is no with-holding taxes (may depend on host country).
Really, can the creation of a well-diversified global portfolio with minimal taxes be any simpler than creating an ETF portfolio of Canadian and international stocks in a TSFA?  I don’t think so. Here is my ETF portfolio:
       1.       Canadian Stocks (XIU or XIC): 40%
2.       US stocks (XSP): 40%
3.       European Stocks: 20% (IEV)

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