This blog is about saving and investing my way to a $1 million portfolio. Hopefully we’ll get there by age 50.
Part of my investment strategy to reach this goal is by using low-cost, diversified Exchange Traded Funds (ETFs) for index investing. I follow 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 (but smart).
We use only equity ETFs for long-term growth. We don’t own any bonds or bond ETFs. We prefer to have a cash wedge instead in retirement.
We index part of our portfolio to:
- Achieve market performance less minuscule money management fees.
- Obtain great diversification.
- “Set and forget” (to some degree) part of the portfolio.
I think indexing inside your tax-deferred (RRSP) and/or tax-free (TFSA) accounts using ETFs can work for the majority of investors. The main reason for index investing is simple: most investors have no hope in beating the index consistently over time. This means instead of trying to beat the market you should be the market.
Even the greatest investor we know says you should index (Warren Buffett). Here’s a quote, from page 20 of his annual letter to Berkshire shareholders, dated February 28, 2013. After all of his Berkshire shares are distributed to charity, take the cash, Buffett says, and just buy index funds:
My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.
He goes on to say:
Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.
So, buy the farm. Your farm is the index.
What could your “farm” look like?
I believe most Canadian investors would do well to own any combination of up to three (3) equity ETFs in their portfolio. That’s all you really need:
- Own a Canadian equity ETF: XIU or XIC or VCN or ZCN (inside TFSA or RRSP).
- Own a U.S. equity ETF: VTI (inside U.S. $$ RRSP) or VUN (inside RRSP).
- Own an international equity ETF: VXUS (inside U.S. $$ RRSP) or VXC or VDU (inside RRSP).
In what accounts should you hold your ETFs?
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.
A Canadian ETF that holds international stocks
example: Vanguard Canada VEE
VEE is a Canadian-listed ETF. 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. Using VEE in a RRSP or TFSA withholding taxes will apply. A Canadian-listed ETF that holds international stocks may double the cost of some ETFs inside a RRSP or TFSA.
A Canadian ETF that holds US stocks
example #1: Vanguard Canada VFV. VFV is a Canadian-listed ETF. 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. Using VFV in a RRSP or TFSA withholding taxes will apply.
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%).
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. If you can own U.S.-listed ETFs inside your RRSP, you should 🙂
Otherwise don’t sweat this stuff and deal with the slightly higher money management fee. The higher money management fee is your cost for simplicity. You don’t have to worry about withholding taxes and you don’t have to worry about any currency conversion from Canadian to U.S. money to buy your U.S.-listed ETFs.
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%. 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”
Finally, check out my Archives page for some of my favourite ETF products.