1) INTRODUCTION:
François Doyon La Rochelle: You’re listening to Capital Topics, episode #63!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.
In this episode, we will discuss the following points:
First, we will give you an update on the result of active vs passive management for 2023.
And next, for our second topic, we will review the 2024 Federal Budget and the New Rules that affect Investors.
Enjoy!
2) UPDATE ON THE RESULTS OF ACTIVE VS PASSIVE MANAGEMENT FOR 2023:
François Doyon La Rochelle: For our first topic today, as we have done in the past, we will look at the results of active management versus passive or in other words, indexing strategies for 2023. This is an annual exercise that we perform. We look at the data from a report produced by S&P Dow Jones Indices which measures the results of the S&P Indices versus active funds. This report is called the SPIVA Canada Scorecard.
James Parkyn: Yes François, in addition to the SPIVA Scorecard we also look at the results of the Morningstar U.S. Active vs Passive Barometer report which compares the performance of active funds against their respective passive peers. Although this is a U.S.-centric report, we feel that it is more complete than the SPIVA report since Morningstar measures the rate of success of active managers against the results of actual passive funds and not indexes.
François Doyon La Rochelle: Yes, James, the difference is subtle but is very important for our listeners to understand. The Morningstar report studies the actual, net-of-fees performance of investable passive funds versus active funds. On the other hand, the SPIVA report simply measures the performance of actively managed funds against their respective benchmark or index. The important nuance here is that a benchmark or an index like the S&P500 in the U.S. or the S&P/TSX Composite Index here in Canada is not investible without incurring fees.
James Parkyn: Exactly François, whether you are using an active or passive fund you will always incur fees, fees for portfolio management, fees for administration, etc. Now that we have highlighted the main difference between the two reports François what are the results of the 2023 SPIVA Canada Scorecard?
François Doyon La Rochelle: Unsurprisingly James, 2023 was yet another difficult year for active management in Canada. But before we look at this year’s report, I just want to set the table and go back quickly to the 2022 results that we covered in Episode #51 of the podcast. I’m sure you remember that 2022 was a disastrous year for both the bond and the stock markets, and contrary to active managers’ narrative that they can position their portfolios to outperform in difficult markets, well their results last year were not great. Less than half of the active funds were able to beat their respective benchmarks during that year.
James Parkyn: Yes, and the report also underlined that although it was a challenging environment in 2022, the markets gave active managers a lot of opportunities to generate relative outperformance.
François Doyon La Rochelle: Exactly and as I mentioned they did not generate relative outperformance. So now for 2023, I’m sure our listeners will remember from podcast episode #59, that the main indexes worldwide delivered fabulous returns, double-digit returns for the most part. Despite this, active managers again failed to deliver since more than three-quarters of active funds underperformed their benchmarks last year. If we look at the main four fund categories, which are Canadian equities, U.S. equities, international equities, and finally global equities, active managers, on an asset-weighted basis for each category, underperformed between 1.7% and 8.4% their respective benchmarks.
James Parkyn: Wow, these are huge underperformance numbers. So François, how does the report explain this underperformance?
François : Well, James, the report highlighted that years of high benchmark performances usually coincide with greater active management underperformance. For 2023, the report states that and I quote “Along with solid index performance came positive skew in the cross-section of constituent returns. In all categories, the majority of constituents trailed their benchmark’s total return.”
James Parkyn: That’s a lot of jargon François, let’s try to explain it in simple terms to our listeners.
François Doyon La Rochelle: What they are saying James is that most of the stocks underperformed their benchmark last year which made it difficult to add value by stock picking. For example, in the S&P500 Index close to 74% of the stocks trailed the index and in Canada, 60% of the stocks trailed the S&P/TSX Composite Index. So, if you did not have good stocks in your portfolio you were bound to fail. That’s what the report stated as the main reason for the underperformance of active managers last year, but our listeners need to remember that over the long run, only a small percentage of stocks generate most of the performance in equity markets.
James Parkyn: François, I presume that the long-term results have not changed and they are still pretty disastrous for active managers.
François Doyon La Rochelle: Indeed James, over ten years, most actively managed funds in Canada have underperformed their benchmark. For the seven asset classes studied, underperformances range from 76% for Canadian small and mid-cap equities funds to a high of 98% for U.S. equity funds. The annualized underperformance vs the benchmarks for the 10 years ranged between a relatively low 48 basis points for Canadian small and mid-cap equities to a high 437 basis points for Global equity funds. The average underperformance for the seven asset classes was 2.31%.
James Parkyn: François, what about the results in the U.S. based on the Morningstar U.S. Active vs Passive Barometer that you mentioned earlier?
François Doyon La Rochelle: Well James, based on the report actively managed mutual funds and exchange-traded funds underperformed their passive peers again in 2023. Their success rate was slightly better than last year with an average of 47% of active strategies beating their average passive counterparts in the year compared with 43% in 2022.
James Parkyn: OK François, isn’t this what we expect from a simple coin toss when looking at short-term one-year results? What are the long-term results? I presume there it’s pretty much the same as 2022.
François Doyon La Rochelle: Yes, you are right James, no big surprise there, albeit with the recent surge, actively managed mutual funds and exchange-traded funds continue to underperform their passive peers over the long term. The average success rate of the 20 different fund categories for the last 10 years is below 25%. Meaning that less than 25% of the active strategies were able to beat their passive counterparts. There is also data in the report going back 15 and 20 years and as you would expect the success rate is even worse.
James Parkyn: Are there any bright spots for active managers?
François Doyon La Rochelle: Well, James, there are fund categories where active management is doing somewhat better, but these are very niche categories like U.S. real estate, global real estate, and corporate bonds. In these three categories, the success rate of active management slightly exceeded 50% over 10 years. One other thing that is worth highlighting and that our listeners should retain is that the success rates for active funds that had the lowest cost are generally much higher than the ones with the highest cost. For example, over ten years, U.S. equity large-cap blend funds with the lowest cost had a success rate of 18.6% compared with only 9.3% for the funds with the highest cost.
James Parkyn: I’m sure these poor results won’t help to slow the outflow of funds from active management to passive.
François Doyon La Rochelle: You’re right James.
James Parkyn: To that point, our listeners should check out Raymond Kerzerho’s, PWL’s Senior Researcher, latest report entitled “The Passive vs. Active Fund Monitor” in which he details the persistent outflow of funds from active management and the massive inflows into passive funds. Passive funds in Canada now have a market share of 16.4%. In the U.S., the market share of passive funds is approaching 50%, it’s now at 47%.
François Doyon La Rochelle: Yes, that’s quite impressive. I would add James that in the world markets excluding North America the market share of passive is also growing fast as it more than doubled in the last decade to reach 31%.
James Parkyn: I think this proves that investors now better understand the benefits of indexing and passive management and that ETFs are great tools for building robust portfolios.
François Doyon La Rochelle: Indeed, James, it’s very encouraging to see the growth of passive management. I’m just hopeful however that investors make good use of the tools and invest in a disciplined manner with an eye on the long-term. I say this because investor behavior has a meaningful impact on performance whether you use active funds or passive funds. We will come back and elaborate on this topic in a future podcast.
3) REVIEW OF THE 2024 FEDERAL BUDGET AND THE NEW RULES THAT AFFECT INVESTORS:
François Doyon La Rochelle: For our second topic, we will do a review of the 2024 Federal Budget and the New Rules that affect Investors. As most of our Listeners already know, the Federal Deputy Prime Minister and Finance Minister Chrystia Freeland presented the Federal budget on April 16th. The 2024 federal budget included several tax measures that will affect Canadian taxpayers. Some of the proposed measures impact the personal tax rules, and some apply to investments held in corporations. So, James Parkyn, where do you want to start the conversation today?
James Parkyn: Well François, the latest Budget, presented almost two months later than usual, introduces many new measures that, in my opinion, reverse long-standing tax policies. The media is reporting that many investors are quite angry about the proposed changes. I for one believe that these measures are very short-sighted and will chase out of Canada many very wealthy citizens who are paying astronomical amounts of tax. This is at a time when we need more of them to help shoulder the enormous burden.
François Doyon La Rochelle: James, why don’t we start with the tax changes affecting individuals and their investments?
James Parkyn: That’s a great place to start François. For Individuals, the good news is there are no changes in personal tax rates. The bad news is the big change is in the capital gains inclusion rate, i.e., the number of capital gains subject to tax, will be increased from one-half to two-thirds on capital gains that exceed $250,000 when realized after June 24, 2024.
François Doyon La Rochelle: How will the higher capital gains inclusion rate affect capital losses?
James Parkyn: Capital losses realized before the rate change will fully offset an equivalent capital gain realized after the inclusion rate change. Net capital losses of prior years would continue to be deductible against taxable capital gains in the current year by adjusting their value to reflect the inclusion rate of the capital gains being offset. This makes your Loss Carry Forwards amounts more valuable after June 24th for gains over $250,000.
François Doyon La Rochelle: The higher tax rate adds up to almost 9% more for taxpayers at the top marginal rates in Ontario and Quebec. Investors will need to look carefully at the unrealized capital gains in their taxable accounts to see if they should realize gains before the June 25th deadline.
James Parkyn: Indeed, these new rules completely change tax planning strategies. PWL Research has developed a great tool to simulate if you should realize the gains or defer them. Interestingly, in most cases, it is best to defer.
François Doyon La Rochelle: Why is that, James? Is it a simple matter of the time value of money?
James Parkyn: Exactly François, if you realize the gain now you pay tax immediately and so have less money after tax to reinvest. But this can be a hard sell because getting people to pay tax in advance is against human nature, which is basically to try and avoid or minimize tax whenever possible. If you defer realizing the gain, then you only pay the tax in the year you dispose of the asset.
François Doyon La Rochelle: Deferring tax is, as most of our regular listeners know, a major benefit of our passive buy and hold broad market investment strategy. For most of our clients, continuing to defer tax will make the most sense for taxable accounts. On another front, the new rules will make things complicated for tax reporting. In the 2024 tax year, you will have to report gains at 50% for the period ending on June 24th. After June 25th, the gains over $250,000 will be taxed at two-thirds.
James Parkyn: Indeed, it will. We are going to have to identify capital gains and losses realized before the effective date and those realized on or after the effective date. For example, taxpayers would be subject to the higher inclusion rate in respect of the portion of their net gains arising after June 24th that exceed the $250,000 threshold, to the extent that these net gains are not offset by a net loss incurred in 2024 before June 25th or any other taxation years.
François Doyon La Rochelle: For more clarity, the annual $250,000 threshold for individuals would be fully available in 2024 so it would not be prorated, and it would only apply to net capital gains realized after June 24th. James, what are some other measures in the budget that affect individual taxpayers?
James Parkyn: There is another change linked to the increase in the capital gains inclusion rate. For Employees, mostly senior executives, who exercise stock options granted by their Employer, there will be a one-third deduction of the taxable benefit above $250,000 to reflect the new capital gains inclusion rate. For situations where the taxable benefit is up to a combined limit of $250,000 for both employee stock options and capital gains, taxpayers will be entitled to a deduction of one-half.
François Doyon La Rochelle: What about the Lifetime Capital Gains Exemption on gains realized on the disposition of Qualified Small Business Corporation Shares? Any changes there?
James Parkyn: Yes François, for Entrepreneurs who own shares in their company and sell them, the Lifetime Capital Gains Exemption (LCGE) will be increased from $1,016,836 to $1,250,000 on gains realized on the disposition of Qualified Small Business Corporation Shares and qualified farm or fishing property after June 24, 2024. Indexation of the LCGE will resume in 2026.
François Doyon La Rochelle: Isn’t there more in the Budget for Entrepreneurs?
James Parkyn: Yes, François. Starting on January 1, 2025, the Budget introduces the new Canadian Entrepreneurs’ Incentive, capital gains realized on the disposition of shares of private companies that meet certain conditions will be subject to an inclusion rate of only one-third. This measure would apply in addition to any available capital gains exemption. The limit will be phased in increments of $200,000 per year until it reaches a lifetime limit of $2,000,000. These complex rules appear generous but are very limited in the type of company shares that would qualify.
François Doyon La Rochelle: What about registered plans?
James Parkyn: There are no changes that apply to the TFSA, RRSP, or RRIF. There are changes to the home buyers’ plan (HBP) withdrawal limit. It will be increased from $35,000 to $60,000 for withdrawals made after April 16, 2024. Also, the 15-year repayment period will be temporarily deferred by an additional three years for participants making a first withdrawal between January 1, 2022, and December 31, 2025. There are also some changes to RESP but we will deal with these in a future podcast.
François Doyon La Rochelle: That’s a lot of change to digest. Is that all on the personal tax side?
James Parkyn: No, I have a couple more changes to share with our Listener. The Feds introduced more tweaks around the edges of the major changes to the Alternative Minimum Tax (AMT) regime introduced in 2023 and applicable now in 2024. For instance, they will allow for an increase in the charitable donation tax credit and the allowance of certain other credits in the calculation of the AMT. The 2024 budget proposes that the tax treatment of charitable donations be revised to allow individuals to claim 80 percent (instead of the previously proposed 50 percent) of the Charitable Donation Tax Credit when calculating AMT.
Finally, the mineral tax credit will be extended for an additional year, covering flow-through share agreements entered on or before March 31, 2025.
François Doyon La Rochelle: We have covered personal tax changes. Now let’s turn to the changes for Investment Corporations. What are they proposing?
James Parkyn: Well François, for Businesses, there will be no changes to corporate tax rates. For Investment Income earned on public marketable securities, there is only one tax rate: a top rate of 50.17% in both Quebec and Ontario.
Like personal tax, the capital gains inclusion rate for corporations and trusts will be increased from one-half to two-thirds on capital gains realized after June 24, 2024. Unfortunately, for corporations, there is no relief from the new higher inclusion rate. As stated earlier, for individuals who realize capital gains of under $250,000, the old fifty percent inclusion rate still applies.
François Doyon La Rochelle: Yes James, but I understand, after years of collaborating with tax specialists, that the Canadian Tax code is structured to ensure Integration. In other words, a $1 earned personally will equal a dollar earned in a corporation and then paid out to the shareholder.
James Parkyn: We have yet to see the analysis from tax specialists about how this will change with the higher inclusion rate. These will come in short order, and we can report back to our Listeners.
François Doyon La Rochelle: So, James, is it fair to say the really big change is all about the Capital Gains inclusion rate increasing to two-thirds from 50%, effectively increasing the capital gains tax rate by 9%? On the other hand, the feds make the case in the budget, that this will only apply to a very small percentage of Canadian Taxpayers.
James Parkyn: Yes François, according to the government, they show statistics that it will only affect 0.13 percent of Canadians with an average income of $1.4 million. The hike is being defended, in part, to ensure the wealthiest Canadians pay their fair share.
François Doyon La Rochelle: I don’t like this approach as it creates a lot of anger in high-income earners who pay a disproportionate amount of income tax. We covered this topic in Podcast Episode #57 published last October when we discussed Canada’s Tax System: Do High Earners pay their Fair share of taxes?
James Parkyn: Exactly right. In that Episode, we reviewed the findings of a Research Bulletin from the nonpartisan Fraser Institute called Measuring Progressivity in Canada’s Tax System, 2023. The Report concluded that high-income earners in Canada pay a disproportionately large amount of tax. The Fraser Institute's 2023 report suggests that the top income-earning families — those making just under $250,000 — pay the majority of Canada's taxes.
Similar data was also compiled by Statistics Canada on those who pay higher income taxes. For example, in 2021, the top one percent income group paid 22.5 percent of all income taxes but accounted for a 10.4 percent share of the country's total income. The top 10 percent income group paid 54.4 percent of all income tax but had a share of the country's total income of 34.4 percent.
François Doyon La Rochelle: The federal government lays out its case for what it believes is not fair, particularly when it comes to taxes on capital gains. I quote the Budget paper: “While all Canadians can benefit from the capital gains tax advantage, the wealthy, who tend to earn relatively more income from capital gains, disproportionately benefit compared to the middle class,” the budget said.
James Parkyn: In a recent CBC News Online Article, Trevor Tombe, a professor of economics at the University of Calgary is quoted: "That word fair is completely subjective. What's needed in any kind of statement around what is or isn't fair is clarity around what the person means when they say that word."Jake Fuss, director of fiscal studies at the Fraser Institute, is also quoted "It's kind of very vague in terms of what governments and policymakers mean by a fair share.” While those tax changes may impact the very wealthiest, Fuss suggested that what is often overlooked is how much high-income earners are paying in taxes.
François Doyon La Rochelle: So, James let’s wrap up the review of our Listener. There will be a lot of Investors reaching out to their financial and tax advisors to get clarity on how to optimize their situation under these proposed rules. This may well generate significant extra revenues in 2024 for governments. But you really must wonder about the future. There will be significant unintended consequences and high-income earners are going to try hard to minimize the impacts.
James Parkyn: For business owners, near-term strategies could involve selling investments or shifting them to personal accounts to take advantage of lower capital gains tax rates before June 25. For individuals, options may include selling large, appreciated assets, such as rental properties or vacation homes, or staggering the sale of securities across more than one year.
Some Canadians may also choose to accelerate their estate planning by transferring assets to beneficiaries by June 25 to lower the tax burden on the estate later. Some Canadians may consider moving to a country with lower taxes.
François Doyon La Rochelle: In Canada, taxes are based on residency, not on citizenship like in the U.S., so that worries me a bit. If we lose too many of these high-income earners then we lose all the future cash flow of the taxes that they would’ve paid in Canada.
James Parkyn: I completely agree with you François, these new rules put the country at high risk of losing many very wealthy taxpayers. To conclude for all our Listeners, we recommend consulting with your financial and tax advisors and crunching the numbers because everyone’s situation is different. Canadians should also consider that the changes may not be forever. The capital gains inclusion rate was first introduced in 1972 at 50 percent before being increased to two-thirds in 1988 and then to a high of 75 percent in the 1990s. In 2000, it dropped twice, first to two-thirds and then to 50 percent.
François Doyon La Rochelle: The big unknown is whether the increase in the inclusion rate will survive a future change in government.
4) CONCLUSION:
François Doyon La Rochelle: Thank you, James Parkyn for sharing your expertise and your knowledge again today.
James Parkyn: My pleasure. François.
François Doyon La Rochelle: That’s it for episode #63 of Capital Topics!
Do not forget, if you would like to submit questions or suggestions for the show, please email us at: capitaltopics@pwlcapital.com
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Again, thank you for tuning in and please join us for our next episode to be released on June 6th. In the meantime, make sure to consult the Capital Topics website for our latest blog posts.
See you soon.