How to keep the tax man off your couch

ETF investors understand the benefits of keeping management fees low, but fees aren’t the only thing causing a drag on your long-term returns. In fact, if your RRSP and TFSA contribution room is all used up, taxes are likely to be a bigger obstacle than fees in your Couch Potato portfolio. Annual fees onETFs aren’t likely to skim more than 0.30% to 0.40% of your portfolio, but taxes can eat up almost half your investment income and a quarter of your capital gains if you’re in the top tax bracket.

Fortunately, ETFs can help reduce your tax bill. By their very nature, traditional index funds tend to have low turnover: they only buy and sell stocks when they’re removed from the index. Low turnover means fewer taxable capital gains are passed along to investors.

What’s more, ETFs have a unique structure that allows them to redeem units without ever selling holdings: something mutual funds can’t do. The most frequently traded ETF in Canada, the iShares S&P/TSX 60 Index Fund (XIU), hasn’t distributed a capital gain in over five years.

One can always rely on the financial industry to come up with even more innovative ways to improve tax efficiency (and clever ways to market them). The ETF business is no exception. And while I’m not usually a fan of complicated investment products, the following new ETFs may be worth a closer look.

Swapping returns

The Horizons S&P/TSX Capped Financials Index ETF (HXF), launched this summer, provides exposure to Canada’s big banks and insurance companies, but doesn’t hold any stocks directly. Instead, it uses what’s called a “total return swap.” The ETF has a contract with a counterparty (National Bank of Canada) that agrees to deliver the total return of the S&P/TSX Capped Financials Index, including dividends. Horizons also launched a similar ETF tracking the energy sector.

In addition to providing almost perfect index tracking, swaps offer a potential tax advantage because they don’t pay dividends in cash. All the dividends are assumed to be reinvested, and you can defer taxes indefinitely until you sell the ETF. At that point, all the growth is taxed as capital gains.

This tax advantage can be even greater with the Horizons S&P 500 ETF (HXS), which uses the swap structure for U.S. stocks. Dividends from foreign stocks are fully taxable, so deferring and realizing them as capital gains can mean significant savings. Just be aware this ETF includes a swap fee of 0.30% on top of its management fee of 0.15%. That makes it more pricey than the alternatives.

Swaps may sound like black magic, but they’re commonly used by pension funds and have been popular in European ETFs for years. They also seem to be catching on here: the three-year-old Horizons S&P/TSX 60 Index ETF (HXT), the first to use a swap structure, is now approaching $1 billion in assets. They do carry some additional risk, but even in the unlikely event the counterparty defaults, the ETF holds cash as collateral, so your principal would not be lost. I’d suggest they’re no more risky than an investment-grade corporate bond.

A touch of class

One advantage mutual funds hold over ETFs is the potential to use the “corporate class” structure. Rather than setting up mutual funds as separate trusts, they can be organized as a corporation that includes a family of funds under the same umbrella. This lets you move money from a stock fund to a bond fund or vice-versa without selling shares and realizing capital gains. The fund industry likes to compare corporate-class funds to a house with many rooms: you can move from one room to another without selling the house.

Right now corporate-class mutual funds are virtually all actively managed, overpriced products unsuitable for index investors. But a new firm, Purpose Investments, launched the first corporate-class ETFs in September. If you build a portfolio with these products you don’t need to make buy-and-sell transactions to move money between ETFs: instead, you can call your brokerage (or adviser) and arrange a switch. You won’t realize any capital gains until you ultimately sell the ETFs.

Because the whole idea of corporate-class ETFs is so new, it’s not clear how easy it will be to make this switch if you’re a DIY investor. Discount brokerages won’t let you place a “switch order” for ETFs online, so you’ll have to call customer service and hope you get a rep who understands what you’re trying to do.

The unfortunate reality is ETF innovators are trying to break new ground but face resistance from brokerages and other vested interests that are slow to change. Founder and CEO Som Seif—formerly of Claymore Investments, renowned for its ETF innovation—says investors should check the firm’s website for instructions on how to switch corporate-class ETFs at your online brokerage: they’ll be posted at www.purposeinvest.com as soon as they’re available.

For more index investing ideas, visit Dan Bortolotti’s Canadian Couch Potato blog.