Some investors have been moving into preferred shares, which pay dividends that are taxed at a lower rate than income.William_Potter/iStockPhoto / Getty Images
Advisors are under increased pressure to maximize investor returns amid expected tax increases, rising consumer prices, and low interest rates that make bonds and savings accounts less attractive. The best option for many is tax-efficient investment funds that can help keep more of their capital in their investment accounts.
There are various tax-efficient exchange-traded funds (ETFs) and mutual funds for advisors to choose from. Many are seeking out these options for clients amid expectations that taxes are set to increase as governments look for ways to pay off rising debt and deficits from the stimulus provided to help individuals and businesses cope with the economic impact of the pandemic.
“Advisors are listening to their clients and looking for different things that they might offer to address the concern [of higher taxes],” says Ome Saidi, portfolio manager at Mackenzie Investments and co-manager of Mackenzie Tax-Managed Global Equity Fund, which launched in July.
The fund uses a variety of tax-management strategies including tax-loss harvesting, favouring long-term holds, and investing in companies with lower relative yields weighed against risk-adjusted return potential.
Mr. Saidi says the strategy helps investors keep more of their money compounding in the markets and minimize the tax drag on their investment performance.
“It’s another way to reduce leakage from after-tax returns and … to maximize after-tax returns through a combination of focusing on capital gains, and also lowering what you paid to the government,” he says.
Alfred Lee, portfolio manager at BMO Asset Management Inc., says advisors need to combine tax-mitigation strategies with ways to generate income in client portfolios.
“Most investors want yield, and they want a more tax-efficient way of getting that yield,” he says.
With fixed-income yields so low, Mr. Lee says many investors have had to rely on the equity portion of their portfolios to generate that yield shortfall.
Some have been moving into preferred shares, which pay dividends that are taxed at a lower rate than income. For example, his company offers BMO Laddered Preferred Share Index ETF ZPR-T as an investment product in this area.
It’s very easy for people to get wrapped up in the tax side of things. ... It’s important to balance that and not have it drive investment decisions.
— Dan Hallett, HighView Financial Group
There are also options-based strategies like covered calls that sell call options. These appeal to investors looking for a high level of income and the potential for capital gains.
“The call options are taxed as capital gains, which are extremely tax-efficient,” Mr. Lee says.
These funds have the ability to carry forward capital losses to apply against capital gains, “making them more tax-efficient for investors,” he says.
BMO offers this option through BMO Covered Call Canadian Banks ETF Fund ZWB-T, for example.
“With [BMO Covered Call Canadian Banks ETF Fund], the underlying dividends get taxed as dividends, but the options are taxed as capital gains,” he says. “It’s more tax efficient. It leaves more in your pocket.”
How to use corporate-class funds
Advisors may also want to put their clients in one of the many corporate-class funds available, which are set up like a company that can hold multiple investment classes. It means the fund can share expenses and spread profits and losses in a way that can be more tax-efficient for unitholders.
They’re often best suited for high-net-worth investors in non-registered accounts as well as for corporate accounts for individuals with private corporations.
Horizons ETFs Management (Canada) Inc. offers these through several Total Return Index (TRI) ETFs.
Jeff Lucyk, head of retail sales at Horizons ETFs, says the structure helps investors control when they take gains and better track their investments.
“I call it statement management,” Mr. Lucyk says.
Some advisors will use the TRI ETFs as part of a broader portfolio mix of passive and active investment strategies, he says.
“A lot of them see that it’s hard to beat an index over time, so if you can get [products] at a low fee or that are tax-efficient, that’s a nice core position,” Mr. Lucyk says. “From there, active managers can look to add additional value by selecting stocks that complement those ETF holdings.”
More advisors are also interested in corporate-class funds this year because there are fewer tax-loss harvesting opportunities given markets are up in 2021, he says.
Where should tax efficiency come into play?
While advisors should seek out tax-efficient products for clients, the strategy shouldn’t dictate all investment decisions, says Dan Hallett, vice-president and principal with HighView Financial Group.
“It’s very easy for people to get wrapped up in the tax side of things,” he says. “Advisors do need to be careful – and I think most are pretty good – but clients can push pretty hard around taxation. It’s important to balance that and not have it drive investment decisions.”
Mr. Hallett says portfolio decisions need to be aligned with the client’s financial goals and risk tolerance first, and then tax efficiency can come into play. Otherwise, advisors may be restricting what products they can offer clients, which can impact portfolio performance.
“If you were to go strictly using tax-efficient products for every piece of the portfolio, at least in my experience, you end up with having to sacrifice your first choice from an investment perspective,” he says.
Mr. Hallett says the focus at his firm is often on long-term investments, which means taxes aren’t triggered by quickly getting in and out of investments. His team also looks for products that are more tax efficient.
“Tax efficiency can come from a product’s structure (e.g., mutual fund corporation) or from the underlying strategy (e.g., low turnover, tax overlay),” he says.
Also, advisors need to do their due diligence on products promoted as tax-efficient to validate any claimed tax advantage, while not all will be the right fit for the client.
Another key factor to consider is that tax-efficient funds may not perform as well as other securities, even if they are tax-efficient, Mr. Hallett says.
“It’s not a guarantee that it’s always going to deliver huge benefits relative to other investments,” he says.
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