Different holdings serve different functions within your overall portfolio. This post will review the different ETFs used in the Robocorp “Rookie” basic portfolio building tool. Robocorp is simply an aid for you as a DIY investor. So, it is important for you to understand what you are using, and why, as you build a portfolio for yourself.
What are exchange traded funds (ETFs) and why use them?
Robocorp uses examples of index-tracking exchange-traded funds (ETFs) to construct a model portfolio. These ETFs are pooled funds, like traditional mutual funds, where you buy a share of the total fund. However, there are some important differences.
- They are listed on the public stock exchanges. That means that they can be easily purchased and sold using a discount broker as shown in this video. Trading ETFs usually costs under $10 and takes a few minutes.
- In contrast to some mutual funds, there are no extra penalties for selling “early”.
- ETFs can be transferred as assets-in-kind if you change brokerages. Conversely, some proprietary mutual funds would require you to sell them and move the cash instead. That could trigger capital gains tax if in a tax-exposed account (like a corporate or personal account).
- There are some actively-managed ETFs, but most passively track an index. That means they do not stock-pick, but simply try to match their holdings with the holdings of an index. Some commonly recognized indexes are the TSX or the S&P 500, but there are hundreds.
Passive index-investing is simple and effective.
Index investing persistently pummels active management approaches over long time periods. The most recent SPIVA data continues to show this. Sure, there are 1 in 10 managers that beat the indexes for periods of time. Good luck picking them in advance. The main long-term predictability is the loss of returns to fees and taxes. You can win by not losing. Here is a good introductory video on ETF index investing.
In investing – simple is good.
Using ETFs makes investing simple. You can simply estimate your risk tolerance using a multi-modality approach to choose a stock
Then, buy ETFs to match that. ETFs hold hundreds or thousands of stocks. So, it makes diversification to decrease investment risk extremely easy.
For those using only registered accounts, it can even be super-simple.
It could even be just two ETFs and four minutes to build a diversified low-fee all-equity portfolio. Most people will also have a bonds allocation, bringing that to three funds. The Canadian Couch Potato Three Fund Model Portfolio is a great example.
There are now even asset-allocation ETFs that will emulate this for you and automatically rebalance for a slightly higher management fee (but still low at 0.22%).
Portfolio building can be more complicated if you face higher taxes.
Asset location optimization is attempting to match investment type and account type. Different types of investments and different account types have different tax and growth characteristics. An optimized portfolio can mesh these together to leverage the strengths and mitigate the weaknesses of each.
That deliberate portfolio design can be more optimal, but also more complex.
The complexity can be overwhelming. Worse, it could be financially crippling if it scares you off from investing. The worst possible outcome. It may not be worth it for those with static portfolios (no longer making new contributions) or with low tax burdens.
Unfortunately, most high-income professionals face significant tax burdens.
With their compressed time-frames to save for retirement, their portfolio usually spills over into taxable accounts. A slightly more complicated five fund portfolio that tweaks some of the ETFs used for taxed accounts is one approach. That can achieve some savings.
Considering the ultimate goals and taxation of different account types in the future when accessing them probably makes an even bigger difference.
This is where Robocorp fits in.
The Robocorp portfolio building tool makes those optimal asset location decisions simple. Probably even easier than having to manually do the math for even a three or five fund portfolio.
ETFs are its weapons.
Why Robocorp uses specific ETFs.
I am not qualified to recommend or sell specific investments and I do not. However, there are specific ETFs built into Robocorp. There are many similar products from all of the major providers like Horizon, Blackrock, and BMO that could also be suitable. Robocorp is meant to be simple and not drown users in options. Plus, I am too lazy to build in hundreds of ETF combinations.
The ETFs used in Robocorp are for illustrative purposes and you should choose whatever investment product best suits your specific situation. Either as a DIY investor or with your advisor. I have no affiliations with any ETF companies but I do have a variety of the ETFs used in my own portfolio.
There are a few special “niche ETFs” in the Robocorp line-up that may serve specific roles. However, it generally sticks with the broadest index funds possible. You lose diversification if you are using a bunch of small niche ETFs.
The Robocorp ETF Line-up & Their Portfolio Purpose
Canadian Equity: Vanguard FTSE Canada All Cap Index (VCN)
Management Expense Ratio (MER): 0.06% Dividend Yield: 2.81%
Strengths: It is in $CAD – the currency in which we live. It pays Canadian eligible dividends which are taxed favorably.
Weaknesses: Canada is only a small market globally (3-4%) and is dominated by the financial and natural resource sectors. A high concentration in Canada decreases our diversification across business sectors.
It also concentrates our risk by tying our fortunes even closer to the Canadian economy. We are already highly exposed to Canada economically. Canada’s financial health directly affects our jobs and the taxes that we pay for government services.
Portfolio Purpose: Equity growth and eligible dividend income.
US Equity: U.S. Total Market Index (XUU & ITOT)
Both track the total US stock market. XUU is listed on the Canadian exchange and ITOT on the US exchange. US-listed ETFs often have lower management fees due to scale. There is also a difference in dividend yield due to an extra layer of foreign withholding tax (FWT) for XUU. Only one of those two layers of FWT can be recovered in an RRSP. Using the US-listed version of an ETF has pros and cons that will be discussed elsewhere.
XUU Management Expense Ratio: 0.07%Yield: 1.61% (Plus 0.30% FWT recoverable in a taxable account, or partially in a corporate account. Not an RRSP or TFSA.)
ITOT Management Expense Ratio: 0.03% Yield: 1.65% (Plus 0.30% FWT that is recovered in an RRSP, taxable account, or partially in a corporate account. Not a TFSA.)
Strengths: It is in $USD – the dominant currency of the world. The US stock market is diverse across a variety of business sectors. It is also huge and represents about 40% of the world’s market capitalization. These ETFs tend to pay lower dividends as the companies (hopefully) use their profits for growth or to increase their share value instead.
Weaknesses: Dividends are taxed at the full income tax rate. There is also a 15% foreign withholding tax on dividends. It is recoverable in an RRSP or taxable account and partially recoverable in a corporate account. Not in a TFSA.
Portfolio Purpose: Equity growth. Exposure to the bulk of the world market.
Similar Funds: VUN (Canadian-listed;MER 0.16%) & VTI (US-listed;MER 0.04%).
Non-North American Developed Equity Markets (XEF & IEFA)
XEF (iShares Core MSCI EAFE IMI Index ETF) is Canadian-listed and holds foreign stocks directly. Holding them directly rather than wrapped in a US-ETF avoids an extra U.S. layer of FWT. There is still one layer of potentially recoverable FWT from the country of origin if held in a taxable account.
MER: 0.22% Yield: 2.68% (plus 0.25% recoverable FWT in a taxable account or partially in a corporate account. Not an RRSP or TFSA.)
IEFA (iShares Core MSCI EAFE ETF) is the U.S.-listed version that also holds foreign stocks directly. The
MER: 0.08% Yield: 2.40% (plus 0.41% recoverable U.S. FWT in RRSP, taxable, or partially in a corporate account. Not TFSA)
Strengths: These hold large mature companies diversely across the globe. They tend to pay higher dividends than
Weaknesses: No one who knows where the growth in the future will be. However, these countries have mature economies that tend to be slower growing. Dividends are taxed at the full income tax rate.
Portfolio Purpose: Equity growth. Diversification around the globe to disperse our regional risk.
Emerging Markets (XEC & IEMG)
These track developing markets like those in China, Asia-Pacific, and South America.
iShares Core MSCI Emerging Markets IMI Index ETF (XEC) is listed on the Canadian exchange and basically holds the US-listed iShares Core MSCI Emerging Markets ETF (IEMG). IEMG holds companies directly. That means that there is an extra non-recoverable layer of FWT within XEC. There are also fewer tax treaties with developing market countries and fund management costs are higher.
XEC MER: 0.26% XEC Yield: 2.04% (Plus 0.4% as recoverable FWT in a taxable account only. Not recoverable in an RRSP or a TFSA)
IEMG MER: 0.14% IEMG Yield: 2.16% (Plus 0.4% as recoverable FWT in a taxable account or RRSP. Not recoverable in a TFSA)
Strengths: This is where the world markets have the most potential for growth as they modernize. They have favorable demographics with a younger population.
Weaknesses: These markets are also higher risk and more difficult to invest in since they are developing! These funds pay dividends that are taxed at the full rate and there are some foreign withholding taxes that may be partially recoverable.
Portfolio Purpose: Higher risk and potential equity growth. Global diversification.
Bond ETFs (VAB & ZDB)
Vanguard Canadian Aggregate Bond Index ETF (VAB) VAB tracks the Canadian Bond Index. It is about 2/3 government bonds and 1/3 corporate bonds.
MER: 0.13% Average Yield to Maturity: 2.7% Average Coupon: 3.2% Average Duration: 10 Years.
Strengths: Low volatility. Inversely correlated to equity price. So, it helps to dampen portfolio volatility. The bonds held are part of a large and highly liquid market. This could also be useful as a source of funds to rebalance after a large equity market draw-down.
Weaknesses: VAB Currently holds premium bonds which are very tax inefficient. The interest paid, called the coupon, is taxed at the high regular income rate. The yield to maturity in VAB is less than the coupon payment. That makes these bonds less valuable when sold on the secondary bond market. This capital loss offsets the higher interest payment. However, it does not fully compensate when the tax is considered. The capital loss gets credited at only half the rate of regular income while the interest is taxed at the full rate. I discuss premium versus discount bonds in more detail here.
Additionally, interest rate yields are pretty low right now. It is fixed income, but not much income.
The BMO Discount Bond Index ETF (ZDB) tracks the Canadian Discount Bond Index. It has similar holdings to VAB in terms of debtors. However, these are discount bonds. That means that they have a lower coupon (interest payment) and a higher capital value on the secondary bond market.
MER: 0.09% Average Yield to Maturity: 2.61% Average Coupon: 2.2% Average Duration: 7.8 Years.
Strengths: Discount bonds pay a lower interest rate, but have an increased capital gain relative to premium bonds. This makes ZDB slightly more tax efficient than VAB and a better way to hold bonds in a tax-exposed account.
Weaknesses: The discount bond market is smaller than the bond market as a whole.
Portfolio Purpose: Smooth total portfolio volatility. A bond ETF that is inversely or uncorrelated to stocks is useful for rebalancing to buy equity at a discount after a market downturn. It a
About the data: Trailing dividend yields are constantly changing as price and earnings fluctuate.
Vanguard funds, the 12 monthtrailing yield as of Jan31, 2018 was used. The FWT was calculated (if applicable) as 15% for U.S.and 8% for non-US (validated against financial statement).
- For iShares/Blackrock, the 12 month trailing yield as of Feb
13,2019was used. The FWT for non-U.S. income sources was extrapolated from their 2017 financial statements. U.S. 15% FWT was used.