Norm Rothery (also featured in this video interview with Jon Chevreau) recently wrote that the ultra-low commissions offered by the discount brokers allow investors with large portfolios to buy the stocks that comprise an index directly and avoid the fees involved in holding ETFs. The concept is interesting but small investors who want to faithfully track an index need a very large portfolio to save money on ETF fees. The simple formula to figure out if it is worth unbundling an ETF is:

Amount at which unbundling an ETF becomes worthwhile = (Number of stocks in the index * Trading commission ) / MER of ETF

XIU, for instance, has 60 stocks, charges a MER of 0.17% and an investor paying $5 at Questrade needs a portfolio in Canadian equities of $175,000 to invest in the underlying stocks directly, assuming he adds money once every year to the portfolio and rebalances at that time. As you can infer from the formula, unbundling becomes practical when the number of stocks in the index is small and the MER is large.

There is one holding in the Sleepy Portfolio that perfectly fits the bill: the iShares CDN REIT Index Fund (XRE). The REIT ETF holds just 12 securities but charges a steep MER of 0.55%. An investor paying trading commissions of $10 only needs to accumulate $20,000 in REITs before he starts to save money by unbundling.

It gets even better — if you are willing to put up with a bit of tracking error, you can hold just three REITs and track slightly more than half the index by putting 50% in RioCan REIT (REI.UN), 30% in H&R REIT (HR.UN) and 20% in Canadian REIT (REF.UN). As REITs are typically a small portion of an investor’s portfolio, the tracking error may not be a huge concern.

Personal Disclosure: We use RioCan REIT as a proxy for the Canadian REIT sector in our personal portfolios.

This article has 19 comments

  1. Hi CC. I’m glad that you pointed out that any market weighted REIT Index in Canada is heavily slanted towards the likes of the monster RioCan. But I have to let you in on something that is probably not as well known…

    I think the one detail that you left out concerning the advantage of owning smaller “junior” REITs is that when they are new, they often have more Depreciation & Amortization than the more mature REITs. As a result, the distributions from the junior REITs are often classified as Return Of Capital when you file your taxes at the end of the year. That basically means that you won’t get taxed on the distribution until some day in the future when you sell it and have to calculate your Adjusted Cost Base. However, if you adopt Warren Buffett’s “hold forever” strategy (never sell it), then all of those distributions are basically tax-free money.

    For me, I bought some junior REITs using leverage, so I borrow money at about 6%, but it’s tax deductible, so my after tax cost is about 4%. These junior REITs generally throw off about 12% distribution on my cost base, and that cash is tax free for as long as I never sell it. So, I’m basically earning an after-tax interest rate spread of about 8% just by using this strategy. Free money in exchange for accepting the risk that the REIT goes bust.

    Of course, I never leverage myself to the point where one of these guys going bust would bankrupt me. But it does form a part of my portfolio – roughly about 15% of my overall total portfolio is in this strategy.

  2. Be careful Phil.
    You can only leverage for securities that provide income. Return of Capital is (as CRA sees it) not income and thus you can get into trouble writing off the interest. A portion of RioCan is RoC and another portion is dividend and thus considered income – here is a case where you CAN use this strategy.

  3. Hi Phil,

    If you do not mind what “junior” REITs have invested in ?
    It seems a good strategy and I’d like to follow.

  4. You didn’t really explain what the result of the formula is. I assume it gives you the amount that you need to be invested in that ETF to make unbundling it worthwhile. Once I figured out, it is useful! Thanks.

  5. CC, your calculations only account for the MER after one year. Unbundling, even with smaller amounts, will save money if planning to hold the stock over the long run.

  6. Canadian Capitalist

    FT: You’re right if the investor has a fairly static portfolio (and doesn’t add or remove from it). Most investors don’t fall in this category. If you regularly add to a portfolio, you need to replicate the index every time you buy in. I’m assuming that the buy in is done once every year and rebalanced at the same time.

    Dave: I’ll update to make that clearer.

    Ryan: I’m not a tax accountant but my understanding is that leveraging to invest in public securities that don’t throw off any income is tax deductible because the stock could pay a dividend sometime in the future. However, you need to be careful with ROC because the ROC portion of the distribution should be used to pay down the loan.

    Phil: I don’t follow junior REITs (even the Canadian REIT) was a new name to me, so I really don’t have a comment. I agree with you that smaller names could be a consideration if the REIT portion is actively managed.

  7. At least with funds you get to easily reinvest your distributions. Your ACB is tracked for you, and your tax return is easily done as you receive T slips. You don’t have to actively monitor the index and buy/sell shares to mimic it. You also don’t get your mailbox clogged with all those yearly reports and interim mailings.

    The downside is that you don’t exactly control when you may have to eat a capital gain flow out. And yes, you have to lose money to the MER.

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  9. Hello,

    Thank you for the informative blog, I’ve learned a lot from you.
    Have you ever reviewed the options of an investor who wants to only invest in ethical / SRI funds? Any leads on this? (of course if it’s something you’re interested to do … )

    Thank you,
    all the best

  10. I think the key idea is to say how much of the ETF do you want to track. Take the iShares CDN S&P/TSX FINANCIALS Index (XFN)
    which charges an MER 0.55%. It has 30 holdings but if you focus just on the big 5 banks and Manulife and Sun, you are covering approximately 78% of the index with only 7 stocks. Do you really need to buy, say, Kingsway Financial to get their 0.13% exposure? I don’t think so.

  11. Hi Mihai,

    For MY “junior” REIT portfolio, I’m heavily weighted in Whiterock REIT (Symbol WRK.UN-T). I also have a smaller holding in InStorage REIT (Symbol IS.UN-T). And as well, I have a small holding in Huntingdon REIT (Symbol HNT.UN-T). There are a few other junior REITs out there which I do not hold as well as some private REITs as well.

    Whiterock is now “in the clear” so to speak, as their payout ratio is below 100% and thus it will mean that they will start to have some small portion of their distribution be taxable. Huntingdon REIT is still overdistributing, so on the one hand, it means that they’re still quite a risky investment, but on the other hand, it means that they are taxed as 100% return of capital. InStorage I haven’t held for very long, so I haven’t compared their tax statements and such, however, the last time I checked, it looks like their line item for Amortization is bigger than their EBITDA, which means that they should also be classified as 100% Return of Capital when tax time rolls around. Again, that generally means that they are overdistributing (100%+ payout ratio), hence it is a risky investment.

    I wouldn’t recommend to make it a large part of your portfolio, but if you have some interest in having some “speculative long term hold strategy” in your portfolio, then you should take a look. As with any advice, you should conduct your own due diligence on the companies. SEDAR has all of the public documents.

  12. To Ryan,

    Personally, I don’t see much of any difference between buying a REIT and buying a rental property from a taxation standpoint. You are buying them both for rental income and in the first few years that you own the rental property (or the first few years of a junior REIT), it always just so happens that the Depreciation & Amortization are large because the capital cost of the property is large.

    The advantage of the REIT is that you can just invest a few thousand dollars in it (ie. take a small position) and you don’t have to manage the property yourself. The advantage of rental property is that it is less likely to go to zero (even if it burns down you still have insurance money and the value of an empty lot). But from a tax standpoint, it is very nearly the same thing.

    In fact, I have been looking around for some good rental properties – but so far I still haven’t found any properties that have a capitalization rate that makes it worthwhile.

  13. CC,
    thanks for the clarification. I had forgotten about the “may pay a dividend in the future” aspect.

    Indeed, I own 2 REITS for the reasons you list.

  14. CC,
    Thanks for the great post, I’ve been holding XRE to fulfill the ‘REIT’ portion of my portfolio, but for the longest time I’ve been wondering if I’d be better off splitting that money between a select few REITs (RioCan being one of my long time favorites). Its always been a side thought and I hadn’t given much more thought, but I think that this article has sort of sealed the deal for me. I’m going to start doing some analysis on REITS again to see if I can get a good mix to make the switch worthwhile.

    Phil, that is an interesting strategy, thanks for sharing it!

    -Bullish Dividends

  15. I see a subtle issue with this strategy. Your input would be appreciated. When you rebalance annually, you’ll need to adjust the weights of most of your securities. This means that on an annual basis you will need to pay a commission on each security traded — even if its a small trade. Unless you are willing to withstand the tracking error, these commissions should be more expensive than the MER.

    This assumes you don’t invest a large amount (175k) annually.

  16. Canadian Capitalist

    Michael: I’m not sure if you are talking about tracking the TSX 60 Index or the REIT index. The REIT index has just 12 components, so you need only $20,000 to track it faithfully for the same cost as holding XRE assuming you pay $10 per trade to rebalance once every year. For the TSX 60 index, you are right that you need a large amount invested to save anything on the MER.

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  18. CC,

    How about unbundling the XRE and instead of buying the REITs with a brokerage, using a DRIP instead. Then not only do you avoid the MER, the trading cost but you would also get about a 3% bonus/discount directly from the trusts.

    The downside is the hassle of setting it up and you would only be able to easily rebalance by making additional contributions, but it should be a very good buy and hold strategy.

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