ETF's (Part Two)

Last week I covered what an ETF is and what different types of ETF’s exist (see ETF's (Part One)). There is a great deal of information to learn on ETF’s so there will likely be Part Three and Four at some point but this week, Part Two will focus more on how ETF’s operate and its advantages and disadvantages.

Any discussion of the advantages and disadvantages of ETF’s must necessarily start with a comparison to mutual funds. So, what is a mutual fund? Like an ETF, a mutual fund is an investment that contains a basket of investments or securities that are chosen by a mutual fund manager or team that you pay to manage the mutual fund. The price of the mutual fund is set at the end of the day once the stock market closes based on the value of the individual investments in the basket.

When you buy a mutual fund through an investment advisor or a fund manager, you may be charged for such things as: 1. A front end or back end fee of a certain percentage: For example, if you buy a $1,000 mutual fund with a 3% front end fee, the manager or firm will take $30 off the top and only $970 will be invested in the mutual fund. Conversely, with a 3% back end fee, the $30 will come out at the end if and when you sell your interest mutual fund. There may be different variations of how exactly the fee works but generally, this is the idea. 2. Redemption fee: This is an amount you pay when you sell your interest in a mutual fund earlier than set.  This is to discourage people moving in and out of their mutual funds rapidly thus causing fees to rack up and administrative costs to multiply. However, non-redemption free mutual funds do exist and 3. Operational fees: These cover the expertise of the fund manager or team and perhaps any advertising or items of that nature.

All of the above expenses can eat into your overall return over the year and on average, mutual fund expenses can range from 0.1% to more than 3% a year. This may not seem like much but if you have larger investments, those fees can add up significantly. If you had $10,000 in mutual funds, with a 5% overall cost, that is $500 every year you are paying just to have your money in the fund.  For high net worth individuals, this cost would obviously rise substantially. 

Enter ETF’s. ETF’s came into the investment picture in part to address the high fees of mutual funds. This lower cost feature is a big part of why so much financial literature discusses ETF’s; people are interested in saving money on fees because they eat into your overall returns on your investments!

ETF's operate as follows:

1. Lower Operating Expenses and Fees: This is perhaps the largest advantage an ETF has over a mutual fund. As you will recall from ETF’s (Part One) from last week, like mutual funds, ETF’s are also a basket of investments. However, unlike mutual funds, ETF’s typically have much lower expenses to operate and manage. There is no front or back end commission you must pay and the operating expenses are much lower as well. So, on this aspect, ETF's may hold the advantage however, if you are a beginning investor and lack confidence with buying ETF's yourself and otherwise managing them, the fees on a mutual fund may be worth it to you. More on this later, but an index mutual fund where there are some fees may be a better bet for beginning investors because, as you may recall from last week's post, an index fund tracks an index and mimics the return of that index. 

2. Diversification: An ETF shares an advantage with mutual funds and that is the diversification element to investing. Because you can buy a pool or basket of investments, if some go up and some go down, you have spread your risk across the basket. You are not exposing yourself to buying one stock and losing all of your money because something happened to that company that perhaps wasn’t expected.

3. Flexibility for Trading: ETF’s trade like a stock throughout the day so they have much greater trading flexibility than mutual funds. At the beginning of your investment journey, you may not need great flexibility in buying and selling your investment but eventually you may want that flexibility and ETF’s allow you to buy and sell during the day. In contrast, with a mutual fund, you must wait until the end of the day before the price will be determined and you will know what you paid for the fund you are buying or what price you will get for selling the mutual fund.

4. Tax Considerations: Here is some basic info on the tax considerations for an ETF, but as you know, I am not an accountant so you should seek out more information to get further details.

After researching the issue of taxation of ETF’s, I realized it is, not surprisingly to almost all of us that pay taxes, complicated!  Overall, if we keep the big picture in mind, tax considerations are likely secondary to the big advantages that ETF’s provide being lower fees than mutual funds and diversification. So, don’t get too overwhelmed and keep the big picture in mind which is to learn and make good investments. However, it is a good idea to be aware of the tax implications because what you think might be a good idea for an investment, could not be such a good idea if you end up losing much of your gain due to taxes. Briefly:

Canadian Taxpayers

1. Unregistered or taxable accounts (a post is coming on registered accounts such as RRSP’s, RESP’s, TFSA’s and RRIF’s but at this point, the main idea is that investments in these types of “registered” accounts can shelter tax owing under various circumstances): For an ETF containing Canadian securities, dividends earned from the ETF are eligible for a dividend tax credit and capital gains are deferred until sale of the ETF at which point they are taxed at half your regular income tax rate. Another way of looking at it, you keep half the gain and the other half is taxed at your regular tax rate.

For an ETF containing US securities, dividends are fully taxable (a 15% withholding tax applies (a tax put on you as the shareholder and it is withheld from your dividend payment) but that amount may be recoverable if you use a foreign tax credit at income tax time). Capital gains are deferred until sale of the ETF at which point they are taxed at half your regular tax rate (same as above for Canadian securities).

2. RRSP’s and retirement accounts: For an ETF containing Canadian securities, tax on dividends and capital gains are deferred until the money is taken out at which point they are taxed like your regular income. Hence the big big advantage to having your investments in a registered account!  You don’t pay tax until later when you are retired and making much less money and therefore your tax rate is much lower.

For an ETF with US securities, tax on dividends and capital gains are deferred until the money is taken out which point you are taxed like your regular income. With respect to dividends, a 15% withholding tax is applied on dividends if the ETF is a TSX (Toronto Stock Exchange) listed ETF. 

3. TFSA’s (a type of registered education account): For Canadian security ETF’s, dividends and capital gains are tax free. For US security ETF’s, dividends and capital gains are held tax free but there is a 15% withholding tax on dividends paid.    

United States taxpayers

Since, I know less about American taxes than Canadian taxes, I turn this one over to Fidelity Investments (Wiley Global Finance. “Benefits of ETF’s.” Fidelity. www. Web. 28 Nov. 2017.) Fidelity states that ETF’s have to major tax advantages compared to mutual funds:

1. Mutual funds incur more capital gains taxes than ETF’s and a capital gains tax on an ETF is incurred only on the sale of the ETF by the investor.  In contrast, mutual funds incur capital gains taxes through the life of the investment.  As with many things in life, it can be better to kick the can down the road on paying any tax and thus, ETF’s take the lead on this aspect – lower capital gains taxes and the ability to defer their payment until later.

2. Dividend taxation is less advantageous as there are two types of dividends, qualified and unqualified. The dividend paid to you is only deemed to be qualified if you have held the ETF at least 60 days prior to when you got paid the dividend. If not, the dividend is deemed to be unqualified. The difference in tax rate is significant as a qualified dividend carries a much lower tax rate of 5-15% whereas with an unqualified dividend, you must pay tax at your normal income tax rate.     

International taxpayers

Don’t mean to leave you out but I have no idea about tax considerations in other countries on your ETF’s! Rest assured there is information on the internet though for any questions you may have to get started.       

There is a great deal more on ETF’s to discuss but for this week, let’s leave it here with the above discussion. Overall, ETF"s are attractive to investors because they provide many of the advantages of a mutual fund but without the added fees. Having said that, the fees on a mutual fund may be worth it to pay if you truly want the advice and assistance with buying your basket of securities.