For regular followers of MDJ, you will know that I’m a fan of both index and dividend investing.  I use index investing for long-term, hands off portfolios, such as my spouses RRSP and LIRA (from her commuted defined benefit pension), and my children’s education fund.

Related:  6 Ways to Index Your Portfolio

I use the dividend growth investing strategy to produce growing passive income to one day achieve financial independence – ideally sooner rather than later.  However, one issue with long-term dividend investing in non-registered (ie. taxable) accounts is the tax leakage.  In other words, all those juicy dividends being generated are also subject to tax.

The Portfolio Leak

While the tax on a Canadian publicly traded company dividend is fairly tax efficient (due to the dividend tax credit), it still creates a drag on the portfolio.  Since a stock market index is a collection of the largest companies in any particular country (or sector) – large blue chip companies generally pay a dividend, thus index ETFs generally have a dividend yield associated with them.  To add to this, international dividends and bond interest are taxed like income, which can be high for some and definitely taxed higher than Canadian dividends.

The dividend yield on an index ETF/fund may be smaller than a dedicated dividend portfolio, but it’s still a tax drag that can add up over the long term while in a taxable account.  Especially so for high-income employees who are already in a high tax bracket.

To solve this tax issue, the most efficient choice is to keep all of your money in tax-sheltered accounts (ie. RRSP/TFSA etc).  However, what if you’ve maxed out all of those accounts and have savings left over that can be invested in the market?  That’s where tax-efficient ETFs come into play.

The Solution for Taxable Accounts

Horizons has created index ETFs that pay 0% in distributions or dividends. Instead, you will only be taxed with capital gains tax when you sell down the road. The dividends are still there but used to compound instead of being paid out.

This is attractive in that the ETFs can grow tax-free while you are accumulating and earning a salary.  Then, when it comes time for retirement and theoretically lower income, you can sell off small portions of your portfolio and only pay capital gains tax.

Next question is, how exactly are they able to do this?  This involves a complicated financial instrument called swaps.  Essentially, Horizons uses National Bank as a counter-party to deliver the returns of the index.  So if the TSX 60 (Canadian large cap index) returns 5%, then National Bank is responsible for paying Horizons 5%.  Sounds risky?  It’s actually not as risky as the word “swap” sounds.  Canadian Couch Potato explains that if National Bank defaults on their payment to Horizons, then it’s only the gain that is at risk, not the original invested amount.  Also, if National Bank defaults, we likely have bigger problems in the Canadian stock market, thus no returns would be owed to Horizons.

The Leak-Free Portfolio

A basic globally diversified indexed portfolio typically involves the following parts:

  • Canadian Index
  • US Index
  • International Index
  • Bond Index

Up until recently, Horizons ETFs was missing tax efficient international coverage but that changed with the introduction of the Horizons Intl Developed Markets Equity Index ETF with the ticker HXDM.  This ETF gives exposure to the MSCI EAFE index which covers developed markets outside North America.

With the missing piece of the puzzle, here is a globally diversified no-leak indexed portfolio from Horizons:

  • Canadian Index (TSX 60): HXT (MER: 0.07% reduced to 0.03% until Sept 2018)
  • US Index (S&P 500): HXS (MER: 0.40%)
  • International Index (MSCI EAFE):  HXDM (MER: 0.50%)
  • Canadian Bond Index: HBB (MER: 0.24%)

If you had 25% of each ETF, the total portfolio would cost about 0.30% which is not bad for a tax-efficient portfolio.  Having the option of using these ETFs adds another weapon in overall tax planning.

For ultimate efficiency, consider opening a non-registered account with a brokerage that allows you to trade ETFs commission-free.  I recently opened a non-registered account with Questrade (her TFSA and RRSP already maxed out) for this purpose.

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For HXS and HXDM, are these two ETFs hedged to Canadian dollars? If there is no hedging, then your potential income can be greatly affected years down the road if the Canadian currency appreciates against the world currencies. If there is hedging, what is the annual cost as part of the portfolio to do the currency hedging?

I am currently using the ishare XSP ETF to invest in the S&P 500 index. This ETF is hedged to the Canadian dollars. I am looking for an unhedged ETF to get some exposure to the USD.

1. FT – thanks for putting this up, I didn’t know about the new ETF. I use the total return swaps in my non-registered acccounts, so this will really help.
2.. The best un-hedged S&P 500 ETF is VFV. XUS is also good. You might want to go with XUU which is even cheaper and has many more stocks in it. However, for non-registered accounts HXS is the best if you are willing to accept the added risks of a swap based ETF.

Thank you for another very informative post. This topic came timely as I am just going to put $25k in a non-registered Smith Maneuver account. I was thinking of using MAW 105 for simplicity. But this post makes me think whether I should do an indexing portfolio. Other than a higher MER, what’s your thought about MAW 105 vs an equally weighted ETF portfolio? Thank you in advance. Cheers, Yun

Oslerscodes and FT, Thank you both for pointing out the zero-income tax consequence. That makes sense.

Doesn’t deferred capital gains count as income in the future though?

Shouldn’t a Smith Maneuver account generate enough income to cover the interest cost?

Careful with swap-based ETFs for a leveraged (ie. Smith Maneuver) strategy. The interest deduction of the investment loan is based upon the investment having the capacity to pay income. Horizon swap-based ETFs dont pay income (nor could they) and the CRA would challenge your investment loan interest deduction.

You might want to recheck the MER’s for HXS, HBB and the new HXDM with Horizons as they seem rather high. Morningstar shows the MER’s to be 0.14% for HXS and 0.17% for HBB. The MER for HXDM was unavailable.

Thanks for the post. I can see the benefit of no dividends during the accumulation face. But I thought one advantage of dividends (from Canadian companies) at retirements was that (depending on income level) those dividends could be close to tax free. If you one is aiming for early retirement the accumulation face should be a shorter period than the retirement one. In this light wouldn’t it be better to have dividend paying ETF (from Canadian companies)? than having to pay capital gain taxes during retirement? And having to deplete the ETF principal (selling stocks), at the same time… Thanks,

Thanks for sharing this alternative! I hadn’t heard of the term swaps before. Since I’ve filled up my RRSP and TFSA space I’ve been investing in my non-registered portfolio. I’ll definitely look into this for tax optimization.

How do these work when it comes to foreign withholding tax?

Thanks

My understanding (which is shaky on these complex products) is that the FWT is a big part of why the swap fee is higher for the foreign versions (there are dividends at some point in the chain unless the whole thing is synthetic).

Do the tax savings actually overcome the higher MER drag?

The comment citing XEF cost is 1.35% including dividend tax is fair.

But comparing it to HXDM’s 0.50% mer without noting the deferred tax cost is misleading.

Cost of HXDM could be calculated as: $11.32/2 (tax) + 0.50% * 1000 (MER) = $10.66 or 1.06% cost.

It’s still a significant cost savings, in addition to the benefit of tax deferral, but is it worth the regulatory, and counterparty risks?

We’d have to check the math on this but assuming you have $1000 today and get 2.8% (XEF) dividend at the lower dividend tax rate…. does the future value 20 years from now at a tax bracket at 40% still make XHT worth it? (We’re assuming taxes will be lower in 20 years and we’ll be making less than $40k?… I expect the answer to be “no” to both.)

I spent time with my financial advisory looking at my LIRA and if we leave Canada for 2 years we should be able to withdraw our LIRA at a 25% penalty (https://www.fsco.gov.on.ca/en/pensions/lockedin/faq/Pages/nonresident.aspx). Assuming the same growth rates, taking the penalty today net $100k more in savings than leaving it and taking the full tax hit down the road. This article feels like a very similar thing don’t you think?

I noticed there is HXS.U.TO and HXS.TO is there any difference?

never mind you can delete this comment .U is for US dollars.

FT, interesting article, thanks. Any specific thoughts on holding these type of ETFs in non-regd corporate accounts?

So if I understand this correctly, HXT would be the perfect option for the Smith Maneuver?

so essentially you are deferring tax like an RRSP, earning interest off the deferred tax with the added benefit of having the ‘dividend’ being taxed as a capital gain in the future, while in a lower tax bracket?

I’m not as sure that these are ideal investments for taxable accounts. The CRA is losing tax revenue with these products.

Income trusts (2006) and corporate class mutual funds (2016) were costing the CRA tax revenue, and they no longer exist.

One must consider the possibility that the government will decide that these derivative based products should no longer exist also. In this case, the derivatives are swaps.

In 2013, there were funds using derivatives (forwards) to improve tax efficiency, and once again, the CRA was losing tax revenue. The government decided to end these funds.

http://canadianfinancialdiy.blogspot.ca/2013/03/budget-shoots-down-tax-advantaged-swap.html
http://www.marketwired.com/press-release/blackrock-canada-announces-changes-to-forward-using-isharesr-etfs-1831816.htm

Anyone investing in these products must consider the possibility that they will end, and that they will pay cap gains tax on all their capital gains.

I’m not as sure that these are ideal investments for taxable accounts. The CRA is losing tax revenue with these products.

Income trusts (2006) and corporate class mutual funds (2016) were costing the CRA tax revenue, and they no longer exist.

One must consider the possibility that the government will decide that these derivative based products should no longer exist also. In this case, the derivatives are swaps.

In 2013, there were funds using derivatives (forwards) to improve tax efficiency, and once again, the CRA was losing tax revenue. The government decided to end these funds.

http://canadianfinancialdiy.blogspot.ca/2013/03/budget-shoots-down-tax-advantaged-swap.html
http://www.marketwired.com/press-release/blackrock-canada-announces-changes-to-forward-using-isharesr-etfs-1831816.htm

Anyone investing in these products must consider the possibility that they will end, and that they will pay cap gains tax on all their capital gains.

can you comment on whether you support these being held in TFSA/RRSP? i’m assuming yes but want to be sure i’m not missing something. thks.

never invested, not knowing

I have taken on with Questrade my first leap into ETF’s. The leak proof idea is critical.
Canadian Index (TSX 60): HXT (MER: 0.07% reduced to 0.03% until Sept 2018)
US Index (S&P 500): HXS (MER: 0.40%)
International Index (MSCI EAFE): HXDM (MER: 0.50%)
Canadian Bond Index: HBB (MER: 0.24%)
I just need to know if there is any need for me to track buys and sells to determine the ACB’s and gains or will Questrade issue me the Tslip that will make the CRA happy seeing their cost base and sold price.
If I need to take on the ACB tracking. I have to start now. Your first hand experience is important, as I could not get enough clarity talking to Questrade.