Archive for December, 2007

Why does an Indexer pick Stocks?

December 20, 2007


In response to a comment on the Canadian Dream blog, Preet of Where Does All My Money Go asked this question:

Why would you ever buy individual stocks to add to your portfolio of indexed products? If I’m not mistaken you do add the odd position or two, do you not? Is that not an “active” strategy?

If I do recall correctly, and you DO purchase individual positions, would you agree? If not, I would be curious as to the rationale…

If you’ve followed this blog for a while you know that I’m a big fan of indexing and I have mostly given up on picking stocks for the majority of our portfolios. However, I still plan to capture Canadian exposure through individual stock positions. So, it’s fair to ask why and I’ll try to explain.

There are two reasons for picking individual stocks: (1) Canadian stocks held in our taxable accounts receive favourable tax treatment in the form of the dividend tax credit. I like to buy stocks with a long history of growing dividends at a reasonable price. With individual stock picks, I can easily double the yield on a Canadian stock portfolio than the underlying index. (2) I love to pick stocks. I find it intellectually challenging to research stocks and find it hard, but satisfying, to patiently wait for buying opportunities and, to be honest, a bit tiresome to read earnings reports to keep track of my holdings.

You’ll notice that, financially speaking, (1) is a reasonable argument but (2) is not. I am under no illusion that I am going to beat the pants off the index. In fact, I recognize that the odds are against outperforming the index. However, I am confident that we will easily meet our financial goals even if I am terrible at picking stocks, so I am okay with my choice. I do increase my chances of being successful by reducing turnover and avoiding “story” stocks. Still, you are welcome to characterize my fling with active investing as yet another triumph of hope over experience. If the experiment turns out badly, the damage will be limited to a portion of our portfolios.

Reader Question on Restricted Stock Units

December 19, 2007


Reader Kevin sent the following question on restricted stock units:

I work for a Canadian branch of a U.S. company. As incentives, we receive both stock option grants and restricted stock units. Since tax season is drawing near, I’m trying to gain a full understanding of the tax implications of both of these awards.

I believe that stock options are essentially taxed as capital gains. Say you were granted options with a strike of $50 and you exercise 500 when the FMV is $100. Your gain is 500*($100-$50) = $25000, and that gets taxed as normal income but there is also some sort of deduction of 50% that makes that gain essentially the same as if it had been a capital gain? So you really only end up paying tax on $25000/2 = $12500?

I found the above info in the fourth paragraph of the section Taxable Income – Employee Security Options Deduction available here.

I wasn’t able to find any information at all regarding Canadian tax treatment of restricted stock units. To continue the example above, let’s say that 200 RSUs have vested and I’d like to sell them when the FMV is $100. The cost is zero, so the gain would be 200*$100 = $20000. But is that taxed as ordinary income or is there anything in place to give RSUs the same preferential tax treatment as options?

Thanks for the question because I had to search for information on restricted stock. Employee stock options work exactly as you describe. Employees are given an option to purchase company stock at a certain price subject to a vesting schedule. A common example of a vesting schedule would be 1/4 of the options vest (i.e. can be sold) in the first year and 1/48th of the initial grant vests every month thereafter.

Restricted stock awards (RSA), also called incentive stock awards, are shares granted in your name as of the date of grant and held in escrow. The shares are called “restricted” because they are subjected to a vesting schedule similar to stock option grants. The shares will not be restricted upon vesting allowing you to sell the shares.

Canadian tax treatment of stock options is favourable as you describe. There are no taxes owed when stock options are granted and only 50% of the stock option profits are taxable when you exercise. RSAs, on the other hand, are taxed at grant in Canada, which makes them unpopular because employees have to pay ordinary income tax on money then don’t yet have.

Restricted Stock Units (RSU) provides similar benefits as RSA but instead of actual shares, employees receive an opportunity to receive stock in the future. This article suggests that RSUs are not taxed at grant and my understanding (based on this article) is that when RSUs vest and are converted into company stock, the value of the stock at the time of vesting will be considered as ordinary income and taxed at your marginal rate. If you are a tax expert or have experience with RSU, I’d love to hear your comments.

QuickTax Disappoints

December 18, 2007


Let’s face it: tax software is a commodity and a program from one vendor can easily be substituted with another if you are willing to put up with a little bit of a learning curve. The realities of the marketplace seem to have escaped the folks at Intuit, the makers of the biggest-selling tax preparation software, QuickTax. Despite my distaste for learning to use yet another tax-preparation software, I am shopping around because:

  1. Despite the big print that says “Prepare up to 20 returns” QuickTax Standard, the 2007 version allows you to prepare just 2 returns, down from 6 last year. You’ll have to pay extra to prepare more than 2 returns.
  2. It’s not clear if QuickTax Standard allows entering investment, rental property or self-employment income. It’s ridiculous that we have to pony up $20 more for QuickTax Platinum to declare a little bit of dividend income.

The good news is that there are plenty of options: CRA’s website lists eight competitors for the 2006 tax year. Maybe this is the year I’ll try out UFile instead. Helpfully, UFile’s website states that the program allows data to be imported from QuickTax and the folks at Financial Web Ring have discovered that UFile has increased the number of returns for 2007.