Indexing

This blog is about saving and investing my way to a $1 million portfolio.  This is our desired investment portfolio excluding workplace pensions, government pensions or any part-time work or income derived from hobbies.  Aggressive but doable!  Read on 🙂

 If you think my dividend investing approach is boring you haven’t seen anything yet.  

Although a major part of our investment strategy to accomplish the lofty $1 million goal is through dividend investing, we also believe investing in low-cost, diversified Exchange Traded Funds (ETFs) that track a reputable index is very smart

We use low-cost ETFs inside our Registered Retirement Savings Plans (RRSPs) for U.S. and international equity exposure.

Indexing – what the heck is that?

The premise behind indexing is simple:

  • You can achieve market performance less minuscule money management fees.
  • You can obtain great diversification from companies and countries from around the world.
  • You can largely “set and forget” (to some degree) the portfolio and achieve long-term growth.

Index investing is a passive strategy that attempts to generate similar returns as a broad market index.

Investors use index funds to replicate the performance of a specific index – generally an equity or fixed-income index – by purchasing exchange-traded funds (ETFs) that closely track the underlying index. There are numerous advantages of index investing. For one thing, empirical research finds index investing tends to outperform active management over a long time frame. Why?  You’re not cherry-picking stocks.  By taking a hands off approach to investing eliminates many of the biases and uncertainties that arise in any stock picking strategy.  Two, since index investing takes a passive approach, index funds including indexed ETFs usually have lower management fees and expense ratios than actively managed funds. The simplicity of tracking the market without a portfolio manager (to cherry-pick stocks) allows providers to maintain modest fees. Index funds also tend to be more tax efficient than active funds because they make less frequent trades.  Third and likely most importantly, index investing is an effective method of diversifying against risks. In other words, an index fund consists of a broad basket of assets instead of a few investments. This serves to minimize unsystematic risk related to a specific company or industry without decreasing expected returns.

I think indexing inside your tax-deferred (RRSP) and/or tax-free (TFSA) accounts using low-cost, diversified ETFs that track a broad market index can work very well for the majority of investors.  The main reason?  Like you read above most investors have no hope in beating the index consistently over time although it can be done!

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.

Top low-cost indexed ETFs for your portfolio

  • Own a Canadian equity ETF:   XIU or XIC or VCN or ZCN.
  • Own a U.S. equity ETF:   VTI (inside U.S. $$ RRSP) or VUN (inside CDN $$ RRSP).
  • Own an international equity ETF:  VXUS (inside U.S. $$ RRSP) or VXC or VDU (inside CDN $$ RRSP).

These are just some examples friends.

You can also consider these top dividend ETFs for your portfolio – steady income combined with some capital appreciation over time. 

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In what accounts should you hold these indexed ETFs?

Diversification is great but it comes at a cost unless you put your low-cost 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 own portfolio.  Consider these options below for your portfolio.

1.Currency Hedging or Not 

I try to avoid currency hedging with my ETFs.  While hedging eliminates currency risks from your portfolio (meaning, you own assets in Canadian dollars only) you’ll pay higher fees because of this avoidance.   I think you want currency exposure.  So, consider owning unhedged ETFs.  

2.Withholding Taxes

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 U.S. 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:

  1. If you don’t have much money to invest it’s probably best to invest with a Canadian ETF that holds international or U.S. stocks.
  2. If you have lots of money to invest, i.e., $25k or more for a fund then consider owning U.S.-listed ETFs inside your RRSP.  You avoid 15% withholding taxes on U.S. ETFs inside the RRSP.

If this stuff is making your head spin, don’t worry.  Don’t let the tax tail wag the investing dog.  Just be mindful that Canadian ETFs that invest in U.S. or international assets may cost you more money.  At the end of the day, by owning low-cost, diversified Canadian ETFs in the first place you’re already on the path to save hundreds if not thousands of your own money that could have been lost to money management fees.

Back to my portfolio here’s what I do!

I hold a U.S.-listed ETF that holds U.S. stocks (example VYM).

As you have read above, low-cost U.S.-listed ETFs make great sense inside an RRSP because U.S.-listed ETFs held inside an RRSP escape withholding taxes of 15%.  Canada has tax treaties with the U.S. 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).

Also, consider owning a U.S.-listed ETF that holds international stocks to keep your fees and withholding taxes low.  Example:  Vanguard VXUS.  This ETF would make the most sense inside an RRSP.  Again, U.S.-listed ETFs like VXUS are subject to withholding taxes depending upon where you own this asset 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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