More Than One All-in-One Asset Allocation ETF?

An all-in-one asset allocation ETF is an elegant and cost-effective solution to DIY investing. The minimal fee of <0.25%/yr should translate to higher net returns compared to high-fee active strategies. It automatically rebalances to manage risk. In fact, its simplicity may also reduce behavioral risk leading to better real-world results. It almost seems too good to be true that one ETF can do all of this.

One argument used against an all-in-one ETF strategy for high-income or big-saver investors is that you miss out on tax planning opportunities. Well, I am here to tell you that you can have your simple and effective cake, and by adding some layers when you are used to baking, you can feast on the tax planning too. No tough math, like converting teaspoons to mL – just sticking with all-in-one asset allocation ETFs.

Usually Just Pick One ETF

There are slight differences between the ETFs from Canada’s best ETF providers. However, you could pick any one of them. There is generally no need to buy multiple asset allocation ETFs for most people. Especially when starting out.

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Registered Accounts? Just pick one ETF.

If all of your investing is done inside of a TFSA, RRSP, RESP, or other tax-sheltered account, then tax planning using more than one ETF is not an issue. Just pick one that suits your risk tolerance and use it. Preferrably, one that is free to trade. I use Qtrade and Blackrock’s XEQT, XGRO, and XBAL are free to both buy and sell on that platform.

Like Blackrock’s X’s, BMO ETFs all-in-ones (ZEQT, ZGRO, ZBAL) also use tax-efficient underlying ETFs that hold foreign stocks directly. Vanguard has the most name recognition, is a bit larger, but the V-flavors come with a slightly higher MER. There are also more non-recoverable foreign withholding tax issues that mostly show up in a TFSA. They are very minor and not worth worrying about.

Below is a high-level overview of the all-equity versions of major Canadian-listed asset allocation ETFs. Whether minor differences in MER, asset allocation, or the underlying indices tracked will make a difference is debatable. Further, which will outperform by a whisker moving forward is unpredictable. So, just pick a provider. Choose the version with an equity allocation that suits your risk tolerance (-EQT 100% equity, -GRO 80% equity, or -BAL 60% stocks). Don’t obsess over minor differences.

Each of these ETFs is actually a bundle of multiple ETFs. Each of those ETFs holds hundreds or thousands of stocks from broad world markets. So, that bundle is extremely diversified. You could try to buy and manage those ETFs individually, but the fee savings are under 0.10%/yr. The hassle, trading costs, and risk of errors are easily higher than that.

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What about further diversification of risk?

Adding multiple all-in-one ETFs to “diversify” is not going to yield an added benefit. The differences in underlying indices tracked are minor with massive overlap. Unsurprisingly, they move together with a correlation coefficient of 0.99 for ZEQT and 1.00 for the others.

Some might argue that using all three major providers helps to protect against the risk of one going bankrupt. I wouldn’t sweat that for several reasons. If one of those providers went bankrupt, there would be ripples and likely nowhere safe to hide. Even if they did go bankrupt as a provider, the ETFs still hold the underlying assets. They could be trapped for a while, or even some losses if there was non-compliance with regulations. That has happened with small providers, but I can’t see that happening at large well-run behemoths like the big three. These companies live or die based on their reputation.

Most Canadian investors truly only need one asset allocation ETF. But, you may be a little bit odd, and not like other investors. After all, you read this blog. There can be some reasons to use more than asset allocation ETF. Particularly, for those managing tax-exposed accounts like a personal account, corporate investing account, or an informal trust for your kid. I will explain some of those potential reasons to use multiple all-in-one ETFs in the next sections.

Tax Loss Harvesting

In a personal taxable account, capital gains or losses offer a chance for some tax planning. You don’t pay taxes on a capital gain until the security is sold. Tax-deferral. You can also boost the tax-deferral of capital gains by tax-loss harvesting. To tax-loss harvest using ETFs, you would sell the ETF with a capital loss and immediately buy a similar, but not identical ETF. That is easy to do by switching to a comparable asset allocation ETF from another major provider.

The opportunity to harvest relies on you just happening to have a capital loss due to investing a bundle of money at an unlucky time. Capital losses can be carried forward to apply against capital gains. They can even be applied back in time up to three years. That reduces the current or previous tax bill. So, you can use your bad luck to your benefit.

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Tax Loss Harvesting With All-In-One ETFs

If you buy or sell the identical asset allocation ETF within 30 days on either side of the trade, the loss would be considered a superficial loss. So, a 60-day window. A superficial loss cannot be used to offset capital gains now. However, it does lower the “cost basis” of the investment. So, when you do eventually get rid of it, the net capital gain would be less due to the superficial loss that was baked in.

Avoiding superficial losses is pretty easy with an asset allocation ETF. You could just change to a different provider with the same stock:bond asset allocation. For example, sell XGRO and buy ZGRO or VGRO. They will all have some differences in the underlying allocations and indices tracked. However, the difference in return would be minor. Plus, it is unpredictable as to what minor difference would outperform moving forward.

After 30 days, you can buy your original asset allocation ETF again when you add money to your portfolio, but with a fresh start on capital gains. When it comes time to start selling ETF units to fund your spending, you can choose to sell from an ETF with a lower capital gain. Plus, it will be applied against the harvested losses before tax is triggered. Less tax due means more money still invested and compounding.

It is a bit hard to visualize over time. So, the diagram below illustrates what it could look like over time using XEQT and ZEQT as an ETF pairing. Fortunately, the actual buying/selling is easy.

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The Sickle of Tax Loss Harvesting Cuts Both Ways

Tax loss harvesting bumps the capital gains tax liability into the future – tax deferral. On its own, tax deferral is generally powerful because it allows the money that would have been paid as tax to stay invested and benefit from compound growth. However, that tax deferral may also translate into tax savings if you realize capital gains at a lower tax rate in the future. People may have lower incomes in retirement. Partners in a household may be able to lower their taxable incomes by income-splitting. That gets easier to do after age 65. So, there is potential for a double benefit.

However, tax deferral may have a downside if you defer from a low tax rate now to a higher future tax rate. That could easily happen. If the capital gains inclusion rate goes up, or the marginal tax rate it is applied to increases – that is a tax increase. You don’t have to look far into the past to see both those things happening. Tax rates have also been higher than they are currently.

That said, tax deferral is powerful. Even with the recent bump in capital gains inclusion from 50% to 67%, (a 34% tax increase), tax deferral overpowers the higher tax rate within 7-10 years. The time frame depends on investment returns. The impact of compounding growth on the deferred tax money is huge over long periods. So, the longer the time before you plan to realize gains, the less risk a future tax increase would pose.

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Avoid Tax Loss Harvesting in a Corporate Account

Tax loss harvesting is most useful in a personal taxable account. You can do it with a corporate investment account too. However, realized capital losses are applied to the capital dividend account (CDA). The CDA must have a net positive balance to pay out a capital dividend. Capital dividends are tax-free and a tax-efficient way to move money out of a corporation instead of using extra salary or dividends to fund a personal splurge or invest personally. Some may want to tax-loss harvest to reduce corporate taxes. However, I prefer to use my CDA to get money out of my corporation tax efficiently.

Cash Flow Tax Planning

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Personal Taxable Accounts To Fund Spending

One of the nice things about having a personal taxable investment account is that it is a pot of money with a small tax liability. I say that because to access it usually just means some capital gains taxes. That will only be on a portion of the money that is a gain. Return of the originally invested capital is tax-free. So, if you sell $1000 of an ETF to access the money, only part of that is a capital gain, and only part of that gain is taxable.

When considering where to draw money from to fund spending, you can maximize the tax deferral in your overall portfolio by triggering the least amount of tax now. Selling from a personal taxable account will trigger much less tax than taking extra salary from your corporation or using an RRSP withdrawal. It is also less tax than paying dividends from your corporation, except possibly eligible dividends in tax brackets under ~112K.

Alternatively, you could take money from a TFSA. However, I hate to think of the lost tax-free growth that represents. Compounded into the future. Plus, you would still need to use taxable income, and pay taxes, to fill that TFSA back up again. Preserving registered accounts, like an RRSP or TFSA, boosts growth over time due to tax-sheltering the interest and dividends.

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Multiple ETFs With Different Tax-Liabilities

If you just use one asset allocation ETF, eventually it will have a large capital gain tax liability. So, selling some to access the cash will have more taxable capital gain and less tax-free return of capital. However, if you start using a second asset allocation ETF moving forward, it will start fresh with a low tax liability. That doesn’t mean selling the original ETF (triggering tax) to buy a second one. I am talking about investing dividends received and new contributions into the new ETF.

Adding a new ETF when you have a large tax liability gives you options. You can sell some of the ETF with the lower capital gain if you need money. That keeps more tax deferral working for you in the ETF with the larger gain. Over decades, you may even use 3 or 4 ETFs. Even though there are multiple ETFs, it isn’t more work. Buying an all-in-one with the same stock:bond allocation keeps your risk the same. You just stop buying more of the older ETFs and add new money (deposits & dividends) to the new one.

Strategic Donations To Charity

You may have noticed that part of the decumulation phase in the above example was donating to charity. I actually advocate for making giving part of your routine financial life rather than leaving it until you are old or dead. Done well, it will make you happier. Regardless, the tax planning opportunity from adding new ETFs over time applies either way.

Donations of appreciated securities, like shares of an asset allocation ETF, to a registered charity has major tax benefits compared to donating cash. So, having the option to donate an ETF with large capital gains while using those with low capital gains for personal spending is a tax planning opportunity. That applies to personal accounts, but it is supercharged when donating from a corporate account.

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Donation of Appreciated Security From Personal Account

The advantage of donating appreciated ETF shares instead of cash is that you remove the tax liability of the capital gain. Plus, you still get a tax credit for the full amount donated. For example, donating $10K of XEQT with an embedded $5K capital gain removes ~2.5K in future tax liability (at a 50% marginal rate). Plus, the $10K donation also generates a tax credit to apply against current taxes from your regular income.

If you gave cash instead, you’d get the tax credit, but you’d still have that $2.5K tax liability someday (and it will grow as your capital gains grow).

There is more information and a tax calculator to illustrate this in my post about giving tax efficiently.

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Donation of Appreciated Securities From Corporate Account

The advantage of donating appreciated securities is even greater with a corporation. Like with personal accounts, it removes the tax liability of the capital gain. The full amount is also a deduction to use against corporate income. That could be used against investment income (usually taxed ~50%) or active income (usually taxed ~12-27%) depending on the situation.

In addition to the tax savings in the corporation, it allows for more tax-free movement of money out of the corporation. The full amount of the capital gain, instead of the usual 1/3, is added to the corporation’s capital dividend account. A positive balance can be used to pay out a tax-free capital dividend to shareholders. That is much more efficient than paying a taxable non-eligible dividend or salary to get personal cash.

So, there is the removal of a tax liability. A deduction against more highly-taxed active or passive income. Plus, personal tax savings when money is moved out of the corporation. A triple benefit. Having an ETF with high capital gains to donate while using those with lower gains to fund spending is a great tax planning strategy.

Easy Tracking of Second-Generation Income

If investing money in a tax-exposed account, the income (dividends and interest) are taxed in the hands of the person who earned the money. These attribution rules are in place to prevent a high-income person from gifting money to their spouse or a minor to invest and earn lower-taxed income. This also applies to money invested for the benefit of a minor using an informal trust.

One nuance of the attribution rules is that second-generation income is not attributed to the high-income gifter. It is taxed in the low-income investor’s hands. Secondary income is interest and dividends received from re-investing interest and dividends.

Capital gains from the gifted investment are taxed in the hands of the gifter if it was given to a spouse. However, another nuance is that capital gains from a gift to a non-arms-length minor are attributable to the minor (not the gifter).

While enabling a lower-income family member may be beneficial from a tax standpoint, tracking can be intimidating.

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Two ETFs make income attribution tracking simple.

Using a second asset allocation ETF could make this simple. Invest all gifted money in asset allocation “ETF A”. The dividends or interest received could then be used to buy a second similar asset allocation ETF, “ETF B”. Both can have the same stock:bond allocation. So, simple risk management and automated rebalancing. If the low-income person uses some of their own funds (attributable to them) to invest, use those to buy “ETF B” also.

That way, you would know that all interest/dividends from ETF A are attributable to the high-income gifter. If the recipient is a spouse, capital gains from ETF A are attributed to the gifter. However, if it is a minor, then ETF A’s capital gains are attributed to the low-income recipient. All interest, dividends, and capital gains from ETF B are attributable to the low-income investor.

You could even use this method to track multiple gifters. For example, an informal trust that has contributions from different parents or grandparents plus arms-length gift money or income earned by the minor. One ETF for each attribution entity.

Right Strategy at the Right Time

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Starting Out

While tax planning is sometimes used as a criticism of all-in-one ETFs, I think that it is yet another example of how they are an elegant solution. You don’t need to worry about any of these tax planning strategies when you are starting out. The most important thing is to have an easily executable and effective plan. A single all-in-one asset allocation ETF is perfect for that. It is also all you need when starting because you’ll want to fill your tax-sheltered registered accounts first. You don’t need more than one ETF for that.

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Years Later

For those saving and investing beyond their tax shelters there is also no need to add a second ETF for a long time. It will take years to grow enough capital gains to make it worthwhile adding a second asset allocation ETF. By then, you’ll be comfortable with the mechanics of managing your investments. Switching to just start adding new money to a different all-in-one ETF instead will be a piece of cake by then.

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Be Aware Now

Even if this doesn’t apply to you right now, it is important to be aware of these strategies. Don’t let someone talk you out of DIY investing using an all-in-one asset allocation ETF by alluding to lost tax planning opportunities. You can address that. Awareness of the option to start adding ETFs over your accumulation years as you accrue unrealized capital gains will also be important to give you those tax planning opportunities when you draw from your portfolio later in life. We invest money so that we have more of it to use later. So, the time to access the money will eventually come. Plan ahead and use it. Build a layered cake, but be sure to enjoy eating some of it while your taste buds still work.