After-Tax Returns on Canadian ETFs

If you hold investment funds outside registered accounts, taxes can take a big bite out of your returns. Unfortunately, comparing the tax-efficiency of similar funds is difficult, because there is no standard method for estimating after-tax returns. In Canada, fund returns are reported on a pre-tax basis, and this can be misleading. Two funds with similar pre-tax returns can perform very differently when you account for the tax investors would pay on the distributions.

To help investors and their advisors make useful comparisons, we’ve created a methodology for comparing the returns of Canadian ETFs after considering the impact of taxes (it also works for traditional mutual funds). The methodology is fully explained in our newly updated white paper, “After-Tax Returns: How to estimate the impact of taxes on ETF performance,” available at www.pwlcapital.com. There you’ll also find our free downloadable spreadsheet, which you can use to measure the performance of your own holdings.

The calculations can be complex and time-consuming, but even if you’re not inclined to dive into the math, you should understand the key concepts when choosing ETFs for your taxable accounts.

The most important lesson is that distributions matter a lot: while many investors actively seek out high-yield securities, these can actually be the least tax-efficient, since bond interest, foreign dividends and the income paid by real estate investment trusts (REITs) are fully taxable. Meanwhile, capital gains are taxable at only half your marginal rate, can be deferred indefinitely, and may be reduced by careful tax-loss selling strategies. Let’s unpack these ideas using some popular Canadian ETFs as examples.

• Extreme Couponing

The least tax-efficient of all asset classes may be bonds with high coupons. While today’s low rates can also mean lower taxes—indeed, many now question the conventional wisdom of holding bonds in RRSPs—that’s not always the case. Your tax bill may indeed be low if your fixed income holdings were purchased at or near their face value. (This includes GICs, which are always purchased at par.) A $10,000 bond or GIC paying 2% generates a mere $200 in annual interest, so even at the highest marginal rate you won’t pay more than $100 in taxes.

However, these days most bond funds are filled with premium bonds: those priced higher than their face value because they were issued when interest rates were higher than they are today. The easiest way to learn whether an ETF is full of premium bonds is to compare its average coupon to its yield to maturity (both of these figures will be on the ETF’s web page). If the coupon is higher, then the fund is predominantly premium bonds.

Thanks to the elegant efficiency of bond pricing, there’s no pre-tax advantage or disadvantage to premium bonds compared with those trading at par. Premium bonds pay more interest, but they will suffer an offsetting capital loss at maturity. So if you ignore taxes—which you can do in an RRSP—it’s a wash (see Table 1).

Of course, if you’re holding bonds in a non-registered account, you can’t ignore taxes, and here’s where premium bonds have a distinct disadvantage. Let’s continue the example in Table 1 where our premium bond has a coupon of 5% but a yield to maturity of 2%. A $10,000 holding pays $2,500 in interest over five years but it will mature with a capital loss equal to the difference between its purchase price and its face value (in this case, $1,363.64). The net pre-tax return to the investor is still $1,136.36 (the total interest payments minus the capital loss), the same as with our bond purchased at par. However, an investor in a 46% tax bracket will lose $1,150 to the taxman. So his after-tax return is actually negative, as shown in Table 2.

This example is somewhat oversimplified, but our analysis has found several examples of bond ETFs with negative after-tax returns in recent years. Consider the iShares 1-5 Year Laddered Government Bond Index ETF (CLF) and iShares 1-5 Year Laddered Corporate Bond Index ETF (CBO). In early January, the average coupon of CLF was 3.79%, while the yield to maturity was just 1.36%. For CBO, the figures were 4.78% and 2.03% respectively, not far off the numbers in our example. The high distributions make these funds very popular with income-oriented investors—CBO is the largest bond ETF in Canada, with more than $2 billion in assets. But taxable investors should understand that those high coupons are extremely tax-inefficient.

What’s an investor to do? If you’re using traditional bond ETFs, consider following the traditional advice and hold them in an RRSP or TFSA. If you must hold fixed income in taxable accounts, look for alternatives that do not hold premium bonds.

The BMO Discount Bond Index ETF (ZDB), launched in 2014, is one option: its average terms and duration are similar to traditional broad-market bond  index funds, but all of the holdings are trading at or below par value, which keeps the taxable coupons low. The First Asset 1-5 Year Laddered Government Strip Bond Index ETF (BXF) is another tax-friendly option since strip bonds (also known as “zero coupon bonds”) are bought at a discount and mature at face value.

Finally, a simple five year ladder of GICs is an excellent alternative. GICs are always purchased at par, and they tend to have better yields than comparable government bonds without additional risk.

• Foreign Dividend Stocks

Stocks can be relatively tax-efficient because much of their return comes from capital gains rather than taxable income. Canadian dividends also receive a generous dividend tax credit that benefits low-income investors in particular. But it’s a different story for those who hold U.S. or international equity ETFs, because foreign dividends are fully taxable.

Consider two foreign equity ETFs: one appreciates in price by 3% and pays a 4% dividend, while the other grows by 5% but pays a 2% dividend. In an RRSP, the total return on both funds is an identical 7%. But in a non-registered account, the after-tax return would be significantly lower for the high-dividend fund.

Table 3 offers an example for an investor in the highest tax bracket, where foreign income is taxed at 50% and capital gains at 5%.

In this example, the high-dividend strategy results in a tax bill over 22% higher. Moreover, this assumes the capital gain is realized at the end of the year. In reality, investors can defer capital gains indefinitely and can potentially reduce them by taking advantage of tax-loss harvesting. If those capital gains can be deferred until retirement and realized at a lower rate, the high-dividend strategy looks even less attractive.

The RBC Quant EAFE Dividend Leaders ETF (RID), for example, has a current yield of 4.64%, about double that of the BMO MSCI EAFE Index ETF (ZEA),  which covers the same asset class but without screening for dividends. If these two funds enjoy the same total return before taxes, the high-dividend fund would be at a significant disadvantage in a taxable account.

The remedy? Think twice about using dividend-oriented foreign equity funds in taxable accounts and consider broad-market funds instead, which have lower yields but more potential for capital gains. If you’re committed to a dividend strategy, hold your foreign equities in an RRSP and consider using US-listed ETFs to reduce the impact of foreign withholding taxes.

• REITs

Like high-coupon bonds, real estate investment trusts (REITs) are popular with income-oriented investors thanks to their high yields, which are often in the range of 4% to 6%. However, the distributions from REITs are typically a combination of return of capital and fully taxable income. Canadian REITs do not typically pay eligible dividends, so there is no tax credit. Distributions from U.S. and international REITs are also fully taxable, like foreign dividends.

A balanced portfolio needs to include bonds and foreign stocks, but while REITs can be a good diversifier, they are not an essential asset class. If you want to include them, hold them in a registered account, even if that means moving Canadian or U.S. equities into your taxable account to make room. If there’s no available room for REITs in your tax-sheltered accounts, it may be best to simply not hold them at all.

Dan Bortolotti is an investment advisor and Justin Bender is a portfolio manager at PWL Capital in Toronto. Dan’s blog can be found at www.canadiancouchpotato.com; Justin blogs at www.canadianportfoliomanagerblog.com.