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One-Decision Asset Allocation ETFs (VCIP/VCNS/VBAL/VGRO/VEQT | XBAL/XGRO) - YouTube
Channel: Ben Felix
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- Investing can be intimidating.
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That is one of the reasons
that banks have been so good
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at convincing their customers
to pay high investment fees
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for supposed peace of mind.
[11]
As the awareness around fees has grown,
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more and more people are deciding
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to manage their own
investments using index ETFs.
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Being a DIY ETF investor
is not particularly hard,
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but up until recently, it was
not particularly easy either.
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Back in 2017, the
simplest portfolio around
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was Robb Engen's four-minute portfolio,
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which consists of only two ETFs.
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If you wanted to reduce
your equity exposure,
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you would have had to buy a
third ETF for bond exposure.
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Three ETFs is pretty simple,
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but it still requires some
thinking for rebalancing
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and some discipline to rebalance
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into whatever asset class
is down at the time.
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All of that changed when Vanguard launched
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their asset allocation ETFs last year.
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I'm Ben Felix, Associate
Portfolio Manager at PWL Capital.
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In this episode of Common Sense Investing,
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I'm going to tell you
about one-decision funds.
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(electronic music)
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Let's start off by talking
about asset allocation.
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At the time of this video being created,
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Vanguard has just launched
two new one-decision funds
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to round out their lineup.
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They now have five asset allocations,
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ranging from 20% equity
and 80% fixed income
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all the way up to 100% equity.
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This makes the one-decision
solution a possibility
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for investors at any life stage.
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For their part, iShares only
has two one-decision funds,
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a 60% equity fund and an 80% equity fund.
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They came later to the
game, so don't be surprised
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if they beef up their lineup over time.
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Within the stock and bond components,
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Vanguard and iShares have made
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some slightly different decisions
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in putting their portfolios together.
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Vanguard allocated 30%
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of the Canadian equity
portion of their portfolios
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to Canadian stocks,
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while iShares has gone with
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a slightly lighter
Canadian allocation of 25%.
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With the slightly lower
weight in Canadian stocks,
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iShares has correspondingly allocated
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slightly more to US stocks than Vanguard.
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In the long-term, none of this should make
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too much of a difference either way.
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In both fund families,
the currency exposure
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has been left unhedged for equities,
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and is fully hedged
back to Canadian dollars
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for fixed income.
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Vanguard has chosen
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to globally diversify their bond holdings
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using currency-hedged
global fixed income funds.
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Research from Vanguard has shown
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that an allocation to
currency-hedged global fixed income
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can meaningfully improve
risk-adjusted returns.
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iShares does go outside of Canada
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with a portion of their
fixed income allocation,
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but only as far as the US,
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still hedged back to Canadian dollars.
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In both cases, the majority
of the fixed income
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comes from Canadian bonds.
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Again, I wouldn't lose too much sleep
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over these differences.
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iShares has put a little bit more emphasis
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on riskier corporate bonds
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in their one-decision
funds compared to Vanguard.
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Vanguard has stuck to
total bond market funds,
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which are heavier on government bonds.
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The credit risk in corporate
bonds could pay off long-term,
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but it could also lead to more volatility.
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Again, the differences here
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are not large enough to worry about
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or push a decision to invest
in one fund or another.
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The way that all of these
products are structured is great,
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from an asset allocation perspective.
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It would be be challenging
to do any better
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by buying the underlying
funds on your own,
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and the one-decision funds come with
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the massive added benefit
of built-in rebalancing.
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Now let's get to the thing
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that everyone seems to be
getting hung up on: taxes.
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Tax efficiency is extremely
important, but so is simplicity.
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Let's take a look at how
these trade-offs interact
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in the case of one-decision funds.
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We will start off with
foreign withholding tax.
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Both iShares and Vanguard were smart
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in the way that they
structured these funds
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to minimize foreign withholding tax issues
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to the extent possible
for a Canadian-listed ETF.
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The only way to make an improvement
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would be to get US and
international equity exposure
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from US-listed ETFs inside
of your RRSP account,
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the trade-off being that you
lose automatic rebalancing,
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and you would need to
convert your currency.
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As an example of this trade-off,
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I estimate the unrecoverable
foreign withholding tax cost
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of VGRO and XGRO
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to be about 20 basis
points per year in an RRSP.
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In a taxable account, there is
no way to make an improvement
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by splitting up the one-decision funds.
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You are no better or worse
off from a tax perspective
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with the one-decision funds
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or with their individual components.
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I estimate the unrecoverable
foreign withholding tax cost
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in a taxable account
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to be less than five basis
points for both VGRO and XGRO.
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It seems that people are afraid
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of holding the one-decision
funds in their taxable accounts.
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Let's be clear. The reason
is not withholding tax.
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So if we are talking VEQT,
the 100% equity Vanguard fund,
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there is no issue in a taxable account.
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The issue with both the Vanguard
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and iShares funds in a taxable account
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is that they own premium bonds
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in their fixed income allocations.
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Premium bonds have coupons
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that are higher than
their yield to maturity.
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This means that your total return
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is coming from a combination
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of a relatively high interest payment
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plus an eventual capital loss.
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The problem here is that
in a taxable account
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you're paying tax on lots of interest,
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and then receiving a capital loss,
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which cannot be used
to offset the interest.
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In an RRSP or TFSA, none of this matters.
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Your pre- and after-tax
returns are the same.
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In a taxable account,
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your after-tax return on a premium bond
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will be lower than it would
be on a discount bond or a GIC
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with the same yield to maturity.
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This is where the fear
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of holding these asset allocation
ETFs in a taxable account
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comes from, and it's a valid fear.
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But let's give ourselves some context
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before running out to the GIC store.
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If we look at a bond with
similar characteristics to VAB,
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the largest bond holding
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in the Vanguard asset allocation ETFs,
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it would have an average coupon of 3.21%,
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a yield to maturity of 2.63%,
and a maturity of 10 years.
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When interest rates go
down, bond prices go up.
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A 10-year bond with a face value of $1,000
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and a coupon of 3.21%
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would increase in price to $1,050
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if bond yields dropped to 2.63%.
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If you buy that bond once
its price has gone up,
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you now own a premium bond.
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Before taxes are considered,
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you will receive the
$32.10 coupon for 10 years.
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And then when the bond
matures at par, or $1,000,
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you will incur a capital loss of $50,
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because you paid $1,050 for the bond.
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Your total pre-tax return is 2.63%,
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which is the yield to
maturity on the bond.
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So far, so good.
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If you instead took your
$1,050 and bought a bond
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that had just been issued
at the current market rate,
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so its coupon matches
its yield to maturity,
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you would receive a lower 2.63% coupon,
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and the bond would mature at
par at $1,050, no capital loss.
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Your total pre-tax return is again 2.63%.
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The same would go for a GIC.
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Now, adding in taxes is
where we see the issue.
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After tax, the premium bond
results in more taxes owing
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because of its higher coupon.
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If you have capital gains to offset,
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the capital loss does help a bit.
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Assuming a 50% tax rate, the
after-tax yield will be 1.18%.
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The after-tax yield of the
par bond would be 1.32%.
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That's an annualized
difference of 0.14% after tax.
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All things considered, that's not so bad,
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especially if it's only on,
say, 20% of the portfolio,
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like it would be in VGRO or XGRO.
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We're talking about a few
basis points of tax drag.
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Even if 40% of the portfolio is in bonds,
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we would currently expect
less than 10 basis points
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in overall tax drag on the portfolio.
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Let's also keep in mind
that yield to maturity
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and average coupon both change over time.
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Take a look at the difference
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between coupon and yield to maturity
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going back to June 2013.
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They have been converging as
interest rates have come up,
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pushing yields higher,
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making the premium bond issue
less and less of a concern.
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This is an issue that will come and go.
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If rates continue to
rise, it should go away.
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Especially if simplicity is the goal,
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I do not think that it makes sense
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to avoid holding one-decision
ETFs in your taxable account
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for the sole purpose of
avoiding premium bonds.
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In terms of asset location,
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or trying to optimize which
assets go in which account type,
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I do not think that
there are any guarantees
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that it will add value to
your after-tax returns.
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On top of that, asset
allocation gets messy
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when you try to optimize
your asset location,
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because assets in the
RRSP need to be reduced
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by the expected future tax bill
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to arrive at your
desired asset allocation.
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Confusing, right?
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I generally recommend
holding the same asset mix
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across all account types anyway,
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so I do not see a problem with
holding a one-decision fund
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across all of your account types.
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In terms of fees, Vanguard
comes in around 0.25% MER,
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while iShares is a bit
lower at around 0.20%.
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In both cases, you're getting very close
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to what you could pay
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by purchasing the
individual ETFs on your own.
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The Canadian Coach Potato
three-ETF model portfolios
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have MERs between 0.12 and 0.16%.
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That's pretty close.
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When all costs are
considered, including MERs,
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foreign withholding tax
in registered accounts,
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and tax drag from premium
bonds in taxable accounts,
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the one-decision funds
are a bit more expensive
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and slightly less tax efficient
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than slicing up a
portfolio of ETFs and GICs.
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I think that the added costs
and a little bit of tax drag
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are easily justified by the simplicity
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and automated rebalancing
of the one-decision funds,
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especially for anyone
that values simplicity.
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Thanks for watching.
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My name is Ben Felix of PWL Capital,
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and this is Common Sense Investing.
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I'll be talking about
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a new common sense investing
topic every two weeks,
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so subscribe, click the bell for updates.
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If you enjoy my Common Sense
Investing video series,
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don't forget to check out The
Rational Reminder Podcast.
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(electronic music)
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