Newsletter February 17, 2018
A Big Excuse For Not Investing In Stocks Just Went Away
Vanguard Canada has introduced three brand new Exchange Traded Funds of Funds that should be of interest to most Canadian investors.
And they should be of particular great interest to the following investors:
- Anyone with at least $15,000 in savings savings who would like it to be invested in a diversified manner that includes some exposure to the stock market but who has struggled with the complexity of how to do so. (Someone with as little as about $3,000 might also benefit as long as they are willing to commit to monthly additions to the savings).
- Anyone invested in mutual funds AND who is concerned about the fees charged but has hesitated to become a self-directed investor because of the complexity and difficulty of choosing specific stocks or specific Exchange Traded Funds.
These new Vanguard Exchange Traded Funds offer Canadians, for the very first time, the ability to very simply “set up” an investment portfolio that is allocated between fixed income and equities and that offers significant geographic diversification while retaining a material allocation to Canada and to achieve all of this with just one security and to do so at a very low fee. While each Balanced ETF is traded as a single security each constitutes a diversified portfolio because each is a fund of seven underlying ETFs and each of those underlying ETFs contain multiple individuals stocks, bonds, or other securities.
Please note that I am not one to “bash” the mutual fund industry. There are many people who have built up sizable portfolios and who never would have done so without the encouragement of a mutual fund sales person / advisor. An article of mine from 2003 indicated that mutual funds were a good choice for some people. Today, I still believe that using mutual funds with some guidance from a bank employee or other mutual fund sales person is a reasonable way to get started investing. My four articles on How to Get Started Investing have a heavy focus on Exchange Traded Funds but also indicate that mutual funds have their place especially for smaller portfolios.
Exchange Traded Funds have long been a great alternative to mutual funds for many investors because of their much lower fees. They also offered diversification but only through a (sometimes daunting) process of choosing at least several different ETFs to achieve that diversification.
Investing through Exchange Traded Funds remains somewhat more complex than mutual funds because it requires that a self-directed account be set up. This can be easily done through any of the larger banks. I have an article that addresses how to get started investing on a self-directed basis.
The large Canadian banks typically charge an annual fee of about $100 if the account or the total of all self-directed accounts in the same household is under a minimum of about $15,000. However that fee is typically waived if the investor sets up a monthly automated contribution of as little as $100 per month.
Vanguard’s new fund of funds have effectively removed the extra and often daunting step of having to choose a number of ETFs or other investments in order to achieve some level of asset balance and geographic diversification in the portfolio. This removes what may have been, for many, a huge barrier to going the self-directed route.
If you would like to get started investing on a low-fee self directed basis but have not taken that step because of the complexity or lack of knowledge then these new Vanguard ETFs may have eliminated your excuse.
These brand new ETFs now trade on the Toronto Stock Exchange. They began trading on February 1, 2018.
Each of the three funds are structured as a fund of funds and are invested in seven underlying Vanguard ETFs. All three funds have a total management fee of 0.22%. This includes the management fees of the underlying funds. In addition, I believe taxes, fees and expenses would add about 0.05% for total fees of just under 0.30%. These fees are approximately the same as an investor would face if they invested directly in the various funds that make up each of the three balanced portfolios. The total fees of 0.30% are far lower than the fees faced by most mutual fund investors which would typically be at least 1.50%.
Each of the three funds includes significant geographic diversification outside of Canada which does lead to currency risk (or reward) which is not hedged. Financial diversification theory would suggest that it is best not to hedge currency risk in the long-term but the lack of hedging can can add to volatility. Typically, hedging is expected to lower volatility at the expense of also lowering long-term returns somewhat.
Balanced ETF Portfolio. Symbol VBAL. 60% equity, 40% fixed income.
Conservative ETF Portfolio. Symbol VCNS. 40% equity, 60% fixed income.
Growth ETF Portfolio. Symbol VGRO. 80% equity, 20% fixed income.
Click the links for more information on each balanced ETF including to see the underlying constituent ETFs and the proportion invested in each.
Investors in these funds would typically choose just one of the three funds based on their desired exposure to equities versus fixed income. I believe it would be quite legitimate and prudent for many investors to place their entire portfolio into just one of these three new diversified ETFs.
Some people would argue that a single security cannot provide proper diversification. My own belief is that given the regulations and given the financial strength of Vanguard there is no need to be concerned about Vanguard defaulting. And I believe the fund of funds nature of these three balanced ETFs provides excellent diversification. That is not to say that I think the particular asset and geographic diversification is ideal. It might not suit the needs of everyone. But I think these new ETFs are an excellent way to instantly get diversified exposure to the markets especially for modest portfolios and especially where simplicity is considered highly important.
Alternatively, these diversified ETFs could be used for a portion of a portfolio. For example, an investor might like to place half of their money into one of these ETFs while taking a much more active approach to the other half of their funds using individual securities.
Thoughts On Income Taxes for Small Businesses and Investors
The Canadian Finance Minister’s potential changes to the rules on income taxes for small businesses and investors has resulted in a huge amount of discussion around those topics.
Business owners and Investors mostly do face substantial income taxes. Therefore it is understandable that they almost universally reacted with stiff opposition and outrage towards any potential increases. But the fact is that business owners and investors benefit from many rules that reduce their taxes in comparison to the level of income tax applicable to higher levels of income from employment.
I find it disappointing and frankly somewhat scary that so many business owners and investors seemed to be so openly hostile to any discussion of any changes that would increase their income taxes. In fairness, that was partly because the finance minister implied that simply following the current rules was somehow cheating, abusive or immoral. Surely, people should at least be open to making a comparison between the taxes on regular employment income versus business and investment income and should be open to the idea that changes might be needed to make the system more fair.
None of us are without prejudices and conflicts of interest when the matter of how different forms of income should be taxed. But I like to think that I am capable of laying out facts honestly even if the facts might suggest that I personally should pay higher taxes on some of my income.
I am not a tax expert. But I have thought a good deal about these matters and offer the following thoughts and observations. If I become aware that anything I say here is in error then I will correct it when I learn of any such error.
Tax Advantages For Businesses
Taxation rules attempt to integrate business and personal income taxes such that if a business makes a profit and pays out a dividend, the total tax paid by the business and the shareholder is similar to what the shareholder would have paid by earning the same amount as employment income.
The goal is corporate tax plus personal tax on dividends approximately equals personal tax on a similar amount of employment income.
However, for a variety of reasons it is very often the case that the total tax paid is lower than would be paid on a similar amount of employment income.
Transformation of income from labour into income from capital: I believe that this is a HUGE benefit. And it is not one that is contemplated to change. This benefit is applicable to most small professional corporations and many small businesses where the main input to the business is the labour of the owner as opposed to machinery and equipment and property or labour of employees. Consider a skilled professional who earns $350,000 after expenses. If this is paid out as employment income then the marginal income tax rate in Ontario reaches 48% at $150,000, 52% at 206,000 and 53.5% at 220,000.
If the professional takes no salary then the income can be taxed at the small business rate totaling 14% in Ontario. If the $301,000 net after tax business income were then paid as a dividend to the business owner, the marginal tax rates would reach 40.4% at $150,000, 45% at $206,000 and 46.8% at $220,000. In that case even with quite low tax rates applicable on the first $89,000 of dividends, there would be little if any savings and the tax integration would have worked well. But often some of this business income would be paid to family members as earnings or dividends to achieve income splitting. And often some of the income would be retained and invested which is also beneficial as I will discuss next. Overall, the benefit of turning what in many cases was income from the owner’s personal labour into business income and paying it out to the owner and family members as dividends (income from capital) or retaining and investing some or all of it can be very beneficial in reducing taxes.
Deferral of taxes by retaining earnings: If a business earns income but retains some or all of the income then the portion of taxes that would be paid as personal tax on dividends is deferred. If the earnings are retained and invested in securities within the corporation for many years then this deferral of taxes can be very beneficial. Some people earn part-time income through a small business in addition to their “day job”. In this case it might be possible to retain all of the the business income and to invest it and thereby defer substantial income tax for many years. Often, it might be possible to extract cash in years when the owner’s marginal income tax rate is lower. And, it is possible to remove half of any realized capital gains with no personal income tax payable.
Tax Advantages for Investors
Individual investors can invest in tax-sheltered plans including RRSP, RESP and Tax Free savings Accounts. In addition to that, dividends and capital gains are subject to lower tax rates than in income from emplyment.
Why is Investment Income Taxed at a Lower Rate than Income From Employment?
It is often argued that investment income should be taxed at lower rates in order to encourage people to invest because that is beneficial to the economy and also makes people less reliant on government assistance in retirement. This may very well be true but I think it remains a debatable point. How can we know what level of investment would have occurred in any case without the favorable tax treatment? How can we know precisely how favorably we should tax investment income? How can we know if this really benefits the wage earners who face higher taxes to make up for the lower income taxes on investment income?
The argument for favorable taxes on dividends relies on the argument that dividends are paid out of after-tax corporate earnings that have already been taxed. That argument seems quite valid in the case of small business dividends where the business owner would argue that she has already paid income taxes as the owner of the business. But I wonder how valid this argument is in the case of dividends from large corporations such as Royal Bank or CN Rail or Loblaws. First, many large corporations manage to pay cash tax rates that are far lower than the statutory rate. In such cases can the shareholders really claim that they have effectively already paid taxes at the statutory corporate rate which is what the dividend tax credit assumes? And, if those large corporations face stiff competition is it not the case that the customers of the businesses really paid the corporate tax? That is if corporate taxes were increased and all competitors faced that, would they not be able to increase prices such that the customers paid the increased taxes?
It has also been argued that investment and business income should be taxed at a lower rate because of the risk involved. That is not an argument that I had heard until recently. I don’t think this argument has any merit for several reasons. First, in theory, the reward for increased risk should be provided in the marketplace whereby riskier endeavors tend to face less competition and can achieve higher profits in the market. Second, we don’t tax income from employment differently based on risk. Not all jobs are equally safe in either sense of the meaning of that word. To my mind, this risk argument is self serving and amounts to grasping at straws.
Business and investment income is taxed more favorably than income from employment. There are many different tax breaks and policies that create that situation. Mathematically, a tax break for one taxpayer has to be made up by higher taxes from others assuming a given level of total taxes are to be collected. It should certainly be fair game to re-examine the tax rules from time to time. But, no rational discussion can occur if everyone takes the position that no change should ever be detrimental to themselves.
February 17, 2018