Indexing

Part of my investment strategy is index investing.  I use Exchange Traded Funds (ETFs) for this approach inside our Registered Retirement Savings Plans (RRSPs).  If you think my dividend investing approach is boring you haven’t seen anything yet.  Using some low-cost indexed ETFs for your portfolio is downright lazy.

We use equity ETFs for long-term growth. We don’t own any bonds or bond ETFs.

Our goal is to earn enough investment income from our portfolio to pay for our living expenses.  We hope to reach that goal by the end of 2023.

Indexing

We index part of our portfolio to:

  • Achieve market performance less minuscule management fees.
  • Obtain great diversification.
  • “Set and forget” part of the portfolio. I honestly don’t even think about these ETFs – ever.

I think indexing inside your tax-deferred RRSP using ETFs can work for the majority of investors. I believe most investors would do well to own any combination of up to three (3) equity *ETFs in their portfolio.  That’s all you really need:

  • Canadian equity – XIU or XIC or VCN (inside TFSA or RRSP).
  • U.S. equity – VTI (inside U.S. $$ RRSP) or VUN for U.S. equity (inside RRSP).
  • International equity – VXUS (inside U.S. $$ RRSP) or VXC or VDU (inside RRSP).

*I own some of these ETFs above.  Some of these ETFs would overlap each other in a portfolio.  Meaning, if you own VXC (with has some U.S. holdings) then you might not even need VUN.  This means many investors could reduce their portfolio to two (2) equity ETFs – how is that for simple?!

My Indexing Approach:

I believe investments in a few low-cost equity ETFs will help us on our journey to financial independence, providing long-term capital appreciation and growth.

  • I only buy low-cost, established ETFs like the ones I listed above.
  • I reinvest all distributions paid by these ETFs.
  • I do not sell our ETFs regardless how far the price falls.  If anything, I buy more when prices tank.

My Asset Location Strategy

Diversification is great but it comes at a cost unless you put your ETFs in the right location.  This is because many countries levy taxes on ETF distributions paid to foreign investors.  Here is a summary of what I’ve learned and how I try and manage my portfolio.

1.Currency Hedging or Not 

I try to avoid currency hedging.  Hedging eliminates currency risks from your portfolio and you’ll pay higher fees because of this avoidance.  I think you want currency exposure.  If you want exposure to foreign currencies then you’re looking for unhedged ETFs.  

2.Withholding Taxes

A Canadian ETF that holds international stocks

example:  Vanguard Canada VEE

VEE trades in Canadian dollars.  VEE is not a hedged product.  VEE is the Canadian version of U.S. version VWO.  Using VEE in a non-registered account withholding taxes will apply (15%) but they are recoverable when investors file their tax returns.  In an RRSP or TFSA withholding taxes will apply with VEE.  This makes the true cost of this ETF inside your RRSP or TFSA more than double the posted MER of about 0.30%.

A Canadian ETF that holds US stocks

example #1:  Vanguard Canada VFV.  VFV trades in Canadian dollars.  VFV is the Canadian version of U.S. VOO.  Using VFV in a non-registered account withholding taxes will apply (15%) but they are recoverable when investors file their tax returns.  In an RRSP or TFSA withholding taxes will apply with VFV.

In summary – if you don’t have much money to invest, it’s probably best to invest with a Canadian ETF that holds international or US stocks and simply pay the higher MER; the higher MER associated with withholding taxes. This way you don’t have to worry about any currency conversion from Canadian to U.S. money to buy your U.S.-listed ETFs.

example #2:  Vanguard Canada VUS.  VUS trades in Canadian dollars.  VUS uses currency hedging and is the Canadian version of U.S. version VTI.  Using VUS in a non-registered account withholding taxes will apply (15%) but they are recoverable.  With the currency hedging AND the withholding taxes applied the MER for this ETF is really closer to 0.50% (instead of the posted MER of about 0.15%). 

When it comes to withholding taxes I prefer to own U.S. stocks or U.S. -listed ETFs in my RRSP.

A US ETF that holds US stocks

example:  Vanguard VTI.  Disclosure:  I own this ETF.  

This ETF makes the most sense in an RRSP because U.S. listed ETFs like VTI held inside an RRSP escape withholding taxes of 15%.  It’s worth reminding you foreign dividends are taxed at your marginal rate.  With U.S. listed ETFs the Internal Revenue Service will take a 15% withholding tax on all dividends received.

The other key point is that Canada has tax treaties with the US and many other countries.  Those tax treaties waive withholding taxes on U.S. stocks or U.S. ETFs in registered accounts like RRSPs, RRIFs and Locked-In Retirement Accounts (LIRAs).  TFSAs don’t apply to these tax treaties, it is not considered a retirement account (even though I do).  In a TFSA you must pay 15% withholding taxes on a U.S. ETF like VTI or U.S. stocks like Coca-Cola.

A US ETF that holds international stocks

example:  Vanguard VWO.  This ETF would make the most sense inside an RRSP.  A U.S. listed ETF like VWO is subject to withholding taxes but these withholding taxes do not apply in an RRSP, RRIF or LIRA.

You can learn more about Foreign Withholding Taxes in these great articles here:

Justin Bender, Portfolio Manager, PWL Capital Inc. and Dan Bortolotti, Associate Portfolio Manager, PWL Capital Inc., “Foreign Withholding Taxes:  How to estimate the hidden tax drag on US and international equity ETFs”

Foreign Withholding Taxes, April 2012, Dimensional Fund Advisors.

Finally, check out my Archives page for some of my favourite ETF products.

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