DRIPing ETFs in Canada

One of the unfortunate characteristics of ETFs is that one does not have the option of having the cash distributions automatically reinvested by the ETF provider (iShares Canada explains why in this FAQ), unlike the case with mutual funds. That means an investor must receive cash and decide how long to accumulate before making a trade to buy extra ETF shares. It is an extra cost and extra effort. As Canadian Capitalist recently pointed out, the reinvestment cost, when calculated as a percentage of the total portfolio, may not be very large. However, for passive index investors especially, who just want to let the funds accumulate in the ETF, it is an irritant. Instead of making small purchases oneself, there is another possibility - the broker may offer the free and automatic service of purchasing extra units of the ETF, what is often called a synthetic DRIP (because it is not a genuine, original DRIP as offered by Canadian companies and funds - see the Canadian Dividend Reinvestment Plans blog for much detailed info and listings).

It seems that there is no comprehensive source of info on ETF DRIPing capabilities on the Web, so I offer the results of my researches into the services of Canadian discount brokers. It isn't a complete or comprehensive list - maybe folks could add their knowledge and everyone could convince the DRIP guy to add this info to his blog and maintain it?

Much of the story is pretty sad, and the info hard to extract from brokers, with one outstanding exception and one ok alternative.

#1 - Questrade - leader by the length of a traffic jam on the 401, no one is even close
If you want to DRIP a variety of ETFs, this is your broker. There is no list of ETFs they will DRIP because they will do them all, including all US ETFs. Oh, sorry there are a very few exclusions. Here is a quote from an email Lynn Suderman, Communications manager at Questrade:
"Questrade offers a free DRiP service to its clients. All details are on our site here: http://www.questrade.com/trading/stocks_dividend_plan.aspx. We don’t have a list of ETFs available for DRiPs because almost all Canadian and U.S. ETFs qualify.(note that foreign ETFs – non-U.S., non-Canadian – are not eligible). Here is our rule of thumb for exclusion:

· ETFs that hold stocks and bonds;

· ETF listed as an ADR

· It’s a short ETF.

At the moment, 16 ETFs are excluded due to the above criteria:

ABERDEEN ASIA-PACIFIC

ACS MEDIA INCOME FUNDS

ANGLO AMER PLC ADR

ATLANTIC POWER

ASSOCIATED BRANDS

CUSTOM DIRECT INCM

FMF CAP GRP LTD

FORT CHICAGO ENGY

HARDWOODS DIST INC

KEYSTONE NORTH AMER

MEDICAL FACILITIES

PRIMARY ENGY RECYCLNG-EIG

STUDENT TRANS OF AMER

TELESYSTEM INLT WIRLS-NEW

UNITS-TIMBERWEST FOREST

UNITS-TAIGA BLDGS PRODS

Add this to the recent announcement that Questrade now offers the ability to hold USD cash within a registered account, unique among Canadian brokers, the company begins to look pretty darn good. Now maybe it's because I am big shot blogger (har, har) but I liked the complete within-the-day responses to my email enquiry to Lynn. It's still not perfect though, because they will only buy whole shares with the distribution, so the remainder of the cash will still accumulate in your account. The higher the price of the ETF, the more cash will be left over; in a worst case, there may not even be enough to buy one share - e.g. AGG, a US bond index fund, has a market price of about US$100 per share; it pays out monthly distributions, which means you must have a holding of about $27,000 to buy one share each month.

#2 Canadian ShareOwner Investments Inc - a fair second place
This smaller broker has a fair selection of ETFs that it will DRIP, including all the Canadian iShares ETFs. The list is actually published here - quite an non-obvious place for it to be in the website but a rep guided me quickly and without hesitation to the right place when I phoned. It enables the reinvestment of every penny of distributions by buying fractional shares, something even Questrade doesn't do. Nevertheless, the list is constrained to more popular ETFs and only a few US ETFs (including the AGG example I used above) and none of those from Vanguard, for example. If they have the ETFs you want, this is your best DRIP broker.

#3-5 blank, as none of the other brokers I looked at deserve to be anywhere near the top for the pathetic coverage, the terrible lack of information on websites, the ignorance of front-line telephone customer service staff in knowing what an ETF is, let alone a DRIP, the slow and time-consuming method of looking it up (most seemed to need to look up from some sort of internal computerized list where it took minutes for each named ETF, some wanted CUSIP numbers not just the trading symbol and one even said I would have to buy the ETF first before they could tell whether it could be DRIPed). Below is a partial list I got of which can be done and which not.

#6 - TD Waterhouse - no on-line list, Yes = XIU, XIC, XSB, XBB, XTR, VTI; No = CPD, XSP, VEU

#7 - RBC Direct Investing - no list, Yes = XIU, XSP, XIN; No = CPD, VEU, VTI, EFA

#8 - E*Trade Canada - no list, Yes = XIU, XIC, XSP; email response a day after telephone contact included no further info as to which ETFs in general could be DRIPed

No Ranking (how can they deserve a ranking if they don't do any ETF DRIPing?)
BMOInvestorline - list at http://www.bmoinvestorline.com/FAQs/FAQ_DRIP.html# but it includes no ETFs; called them to check since the list is dated March 2007 but they said they don't do any US ETFs

CIBC Investor's Edge - no list; still waiting for an email answer four days later since rep could not find answer while I was waiting; a post of Jan.29, 2007 (is this still accurate?) on this Canadian Business.com forum by bindexit says CIBC will DRIP Canadian iShares but no US ETFs.

For others like ScotiaMcLeod, National Bank, QTrade etc listed on Rob Carrick's Globe review and ranking of discount brokers, I have no information.

Those interested can also read the informed discussion on this Financial Webring Forum thread "DRIP through RBC".

Update Jan.27 - I posted a note on the Financial Webring about the lack of info about ETF DRIPing and a certain Operabob has created a thread on the DRIP Investing Resource Center to collect any info people might have on what various brokers will do. So I invite you to contribute to that discussion with your info.

Investing an Inheritance: How to do a "File and Forget for Forty Years"

Most of us save for retirement in tax-deferred accounts like RRSPs and LIRAs. But what happens when you suddenly receive a large lump sum and you do not have RRSP contribution room, in other words you must invest in a taxable account?

Here's a situation I've come across recently that got me thinking and researching. (Initially, I thought it was simple but it has taken me some time to figure it out to get the practical details right.)

Situation:

• $50,000 inheritance, specified in the will to be "for retirement"; a very wise thing the person who died has done, creating a very strong moral, if not legal impediment to spending the money since half the battle of saving is actually doing it; I would note in passing that the person receiving the inheritance does not have to include the amount in income and pay tax since that would already have been done in the process of settling the estate; I would also note that it is not a testamentary trust, which could absolutely ensure that the money not be touched till retirement.
  
• 40 years till retirement; the person is in his twenties so the planning horizon is at least that long; due to the above-noted restriction on the lump sum, it is highly likely that the actual time horizon will correspond to the planned horizon - in other words, people frequently suddenly decide that their "retirement nest egg" needs to be cracked open for an omelette craving today, thus blowing the value of a long term approach to smittereens.
  
• No RRSP room: the inheritance must go into a taxable account, which means that income taxes for various types of investment returns (interest, dividends and capital gains) can play a crucial role in net returns, especially over the long term; though the person could or should intend to move the investments progressively into an RRSP as his career advanced and contribution room became available, in this case, his apparent career orientation into government or educational jobs suggests that one of those golden defined benefit plans will use up most or all of tax-deferred pension room, so it is better to plan as if it will not happen
• Maximize net after-tax wealth: obviously ... but he is not interested in high-risk investments that may suffer absolute final losses, as opposed to waiting through market ups and downs, and subject to the following constraint,
  
• Zero maintenance and attention portfolio: the person would ideally like to have to do nothing at all for forty years! No buying and selling, no rebalancing, nothing, if at all possible; unfortunately, it is still required to file a tax return every year, so tax reporting simplicity is a consideration. As a consequence, things should be as simple as possible - few holdings at one broker.

General Principles: these should always apply to investing

• low costs - paying higher fees for others to manage your investments is a sure way to end up with less; 0.1% less per year can add up to many thousands difference after 40 years - 4.1% return compounded will see $50k reach $240k while 4.2% yields $249k; high MERs = low net returns; this eliminates from consideration all equity mutual funds except index trackers
  
• diversification - the "not all eggs in one basket" and "some go up while others go down" factors entail being invested in many assets with as low as possible correlation with each other; this ensures that there is a net gain, not a loss, over the long term
• tax-effectiveness - deferring and reducing taxes means a greater net in the future; tax rates in Canada are lowest on dividends, higher on capital gains and highest on interest as this previous post on tax rates shows. There is a significant advantage to dividends for all taxable income up to the mid-$70k range, which is where our person is most likely to end up based on his career path. However, the portfolio diversification principle must be respected - meaning that it is not acceptable to ignore the fixed income component of a well-structured portfolio merely to avoid taxes. Fortunately, there is a way - substitute preferred shares returning dividends for bonds returning interest income.
  

The Proposed Solution: this is necessarily a combined solution of portfolio and broker/financial service provider due to the practical constraints outlined below; theory may tell us to do things a certain way but it is not quite possible in practice.

There are three good alternative solutions, the best ranked first.

1. Portfolio of Four ETFs at Questrade

Portfolio Composition:

• 35% / $17,500 XIC - iShares Canadian Composite Capped Index Fund, MER 0.25% (the alternative is XIU, the TSX 60 fund, which has a lower MER of 0.17% and distributes much less income as interest, but it only includes the 60 largest companies as opposed to the 270+ companies in the Canadian market, which means less diversification as the 60 only account for three-quarters of total market value of the TSX and presents less opportunity to benefit from small company growth, from income funds and from real estate); negatives of XIC are the MER and the fact that some of the annual distributions are higher-taxed interest; XIC exemplifies the simplicity and advantage of a fund that enables one to own a piece of a large number of assets/companies through one purchase; in the proposed portfolio XIC is the Canadian equity asset class
• 15% / $7,500 VTI - Vanguard Total Stock Market ETF, MER 0.07%; this is a broad market index, representing some 95% of the total US market according to Vanguard; it is exposed to USD vs CAD currency swings, which can be good or bad, depending on the direction; to some degree, there is also a diversification advantage (see discussion in a Burgundy Asset Management paper and research by Mark Kritzman - when the Canadian market falls, often the Canadian dollar follows, meaning that a VTI owner will end up with more Canadian dollars (as long as the US market doesn't fall by the same percentage); alternatives might be IYY and IWV, two index ETFs that track the broad US market but they have higher MER of 0.20%
  
• 20% / $10,000 VEU - Vanguard FTSE All-World ex-US ETF, MER 0.25%; provides very broad exposure to some 1300 companies in 47 countries around the world outside the USA
• 30% / $15,000 CPD - Claymore S&P TSX CDN Preferred Shares ETF, MER 0.45%; this is the fixed income portion of the portfolio, in which preferred shares are substituted for the bond funds typically held in registered tax-deferred portfolios; preferrred shares produce dividends so the person in a middle tax bracket will lose only about 8% to tax vs 30% - preferred shares pay less than bonds (James Hymas says about 0.89% for corporate bonds) in an article Corporate Bonds - or Preferred Shares? in the May 2006 Canadian MoneySaver) but compound the tax difference over 40 years and the difference is enormous e.g. 6% gross on $15,000 bonds would net reinvested and compounded after annual tax at above example rates $77,767 in bonds and 5.1% on dividends would net $93,892; note that bond funds always include lower yielding government bonds so this comparison understates the after tax advantage of preferred share dividends; the alternatives to CPD are three closed end funds DPS.UN - Diversified Preferred Shares Trust, PFR.UN - Advantaged Preferred Share Trust and PFD.PR.A - Charterhouse Preferred Share Index Corporation according to Portfolio Construction in the July/August 2007 Canadian MoneySaver issue but a cursory look suggests they suffer from making large distributions of return of capital, which is just giving his own money back to an investor, as well as trading often at well-below NAV.

Why the portfolio allocation proportions and holdings?

This is perhaps the most uncertain area. While the whole world is represented, Canada has a much larger proportion of total equity - equal to the sum of the USA and the rest-of-the-world - than in my own portfolio. The logic is simply that the person is likely to live and retire in Canada and use Canadian dollars. The foreign holdings introduce a significant enough exposure to diversification benefits from the equities themselves and from currency swings, but not too much. I've wrestled with this in the past e.g. this post on IFA Canada's model portfolio and this post on my own portfolio but cannot find the "perfect answer".

What does the above portfolio achieve?

• diversification through diffuse ownership of a large number of companies
• diversification through investment in most areas of the world
• diversification through equity and fixed income asset classes that move in different ways at different times (but which all move upwards over the long term)
• higher net returns through low fees of the ETFs
• higher net returns through use of a discount broker, which will charge nothing for account administration or management and only charges for trading
  
• higher net returns through lower taxes
• zero maintenance through index tracking - the fund managers regularly restructure the holdings to reflect market evolution requiring nothing of the investor
  
• zero market knowledge and investigation required - you get the market average automatically year after year, sometimes that is down but mostly it is up and certainly over the long term it is up
• zero maintenance through automatic dividend/distribution reinvestment by Questrade
  
• minimal administration through the small number of funds requires less work to do annual tax returns for distributions and down the road when they are eventually sold
  

What does it not achieve and what are the risks?

• rebalancing to keep the portfolio proportions the same will not happen without selling and buying by the investor; rebalancing every four years or so, or when one holding gets more than 5% (e.g. XIC goes up to 41% or down to 29%)out of whack, is the optimal strategy (see this post for discussion); over many years, the equity investment growth should far outstrip the fixed income CPD, which will increase the overall riskiness of the portfolio; normally, that's a cause for concern and the reason for rebalancing; in this case it is quite possibly a good thing, a worthwhile natural evolution. Why? As this person gets older and if, as expected, he begins to build up a defined benefit pension plan paying a fixed inflation-adjusted income at retirement, that in effect has increased the fixed income portion of his total personal wealth.
  
• shifting the portfolio into an RRSP for tax deferment and tax-protected growth as and when that becomes possible can only happen with monitoring and action by the investor; contributing the funds in-kind is possible but that will trigger a deemed disposition and the necessity to calculate and declare capital gains along the way, more work for the investor; the first thing that should go into the RRSP is fixed income, but the CPD should then be sold and replaced by a purchase of a bond fund like XBB the iShares Canadian Bond Index Fund since bonds will produce a higher gross and net (once protected from taxes) yield
• keeping a record of the Adjusted Cost Base of ETFs is a manual procedure as I explained in this post and it is a pain in the you-know-where; it doesn't really need to be done till the ETF is sold and the gain is to be reported on a tax return so maybe it can be put off and done in one massive catch-up session after 40 years but I'd want to not be further than five years behind simply because corporate fortunes rise and fall, companies come and go and records disappear or become hard to find (I had a lot of trouble some years back trying to figure out mutual fund ACBs to do final returns going back a mere 20 years)
• potential instability of the solution is an inescapable risk, especially over forty years, since the practical evolves greatly e.g. forty years ago, index funds did not exist and there was no capital gains tax in Canada; change will happen, it's just not possible today to know where, when and to what degree; one thing to remember is that big does not equal absolutely safe, stable or permanent - the current financial turmoil is affecting most the world's biggest banks, some will fall and over the long term, most will fall (just check the stock listings of the TSX, oops it used to be the TSE, 40 years ago and see how many names you recognize); Questrade is a relatively new, smaller player and going with them entails a degree of risk that it will be necessary to shift the portfolio to another institution if they run into business problems ... or maybe their superior product will see them grow into the dominant broker of tomorrow; is CIBC a good place to be, they seem to keep stumbling? Regardless, it will always be necessary for the investor to keep a general eye on developments for this maximum passivity portfolio.
  

Broker: All ETFs produce cash distributions, either monthly, quarterly, semi-annually or yearly, and there is no option, like there is with mutual funds, to have the ETF manager reinvest the cash automatically. So the investor can do it at his own time and expense or a broker can offer the service. But the objective is to have everything run on autopilot. The choice of Questrade boils down to one thing - Questrade is the ONLY Canadian discount broker I found that could reinvest the cash distributions for all the above ETFs so that the cash would not sit around in the account earning little or nothing. CPD was a particular no-can-do for everyone but Questrade and we see above above, it is a key element of the plan.

2. Portfolio of DFA Mutual Funds described on IFA Canada from Advisor De Thomas Financial.

This approach consists of handing over the $50k to De Thomas Financial for them to invest in the DFA mutual funds described in detail on the IFA Canada website. They follow passive indexing principles to the nth degree, they say convincingly enough (i.e. they back up their assertions with believable data) even more than the various index ETFs. The breakdown of asset classes is more numerous, enabling reductions in volatility and higher returns. Though De Thomas charges a 1% annual fee on top of the 0.25-0.70% embedded in DFA funds, their approach makes up for that 1.25 to 1.7% vs 0.07 to 0.45% ETF fee spread by lower tracking costs, by stock lending revenue and by tax deductibility of the fees (on taxable accounts only). Michael Hill of IFA Canada & De Thomas explained all this in my Q&A blog post of Oct.23. The end result is that the investor should attain a higher net return. The fact that the holdings are mutual funds eliminates the special ACB record-keeping hassle of ETFs, as well as the reinvestment of distributions problem. The rebalancing issue goes away too since De Thomas does it. Finally, part of the De Thomas service is general financial advice (I notice that Mr. Hill is a Certified Financial Planner, one of the better designations) and that may come in handy.

My biggest concern is that all of the portfolios have only bond funds and none with preferred shares and so taxes will be considerably higher. Another is that the "Easy Chair" portfolio for accounts smaller than $100,000 (the minimum required to do the full asset allocation using all the funds) has some limitations but those are not described.

3. Portfolio of TD Canada Trust e-Series Mutual Funds

This portfolio mimics the ETFs in the first portfolio with the difference that they are mutual funds available only through having an account at TD Canada Trust. The funds are:

• TDB900 - TD Canadian Index Fund, MER 0.31%, tracks the TSX Composite Index (it doesn't appear to be a capped fund like XIC, which limits any stock to no more than 10% of the fund; this shoudn't cause any difference or problem as long as there is no tech bubble II where Nortel gets up to 30% of the total value of the TSX!)
• TDB902 - TD US Index Fund, MER 0.33%, tracks the S&P 500, which is only three quarters or so of the total US market and really only tracks large companies, a disadvantage since small company stock returns historically have outperformed large company returns
• TDB911 - TD International Index Fund, MER 0.48%, tracks the Morgan Stanley Capital International Europe, Australasia and Far East Index("MSCI EAFE Index"), which is probably quite a bit less diversified ( we cannot tell because TD's fund information on the above website is too incomplete) than VEU
• TDB909 - TD Canadian Bond Index, MER 0.48%, tracks the Scotia Capital Universe Bond Index ("Universe Bond Index"); because it's a bond fund in a taxable account this is much less desirable than CPD
  

The TD funds do offer the advantages of mutual funds over ETFs already noted above but the higher MERs and a bit less ideal diversification characteristics promise lower long run returns. The biggest negative is the absence of a preferred shares fund. Of course, it would be possible to take the $15,000 for fixed income, go to Questrade and have an account only for that holding there. But why start to complicate life with accounts here and there if there is a better overall solution with Questrade?