đşđ¸Expat, Steal Your Investing Recipe
ETFs are great investment tools that are very costly for đşđ¸ expats. Copy an ETFâs recipe to create your own clone and bypass the costs.
Why invest?
So youâre fortunate enough to have some extra money. Maybe not a lot, but enough to save for the future.Â
Youâd like to grow that money, but you realize that the interest paid on savings accounts is miniscule. Real estate is expensive and difficult to buy and sell. Is there a better alternative?
Surprising as it may sound, becoming a partial owner of a public company is a good alternative. You can buy a small â or large â stake or âshareâ in a company by purchasing its stock on a national stock exchange. But isnât that for the 1%, not for someone of more modest means?
Actually, itâs quite easy to buy shares, and you donât have to be wealthy to do so. Many companies share their income with shareholders through dividend payments. The value of a companyâs stock can also increase. If so you can sell some or all of your shares for more than you paid for them.
There are risks however. Your chosen company may do badly for unanticipated reasons, like a pandemicâs impact on a cruise ship company. Then the value of the company and the stock declines. That means your shares lose value as well.
Stock prices that decline often recover, but that recovery can take time -- sometimes years. Given that possibility, are there ways to own stocks so as to minimize some of the risk of such losses?
One basket or many?
Experience and research have shown that ownership of a single companyâs shares can be quite risky. Itâs far safer to invest in multiple companies. One company may do badly, but itâs unlikely that all will do badly simultaneously. When you own shares in multiple companies, losses from one company are often offset by gains from another.
If those companies are in different types of businesses, the specific circumstances that hurt one company are less likely for companies in very different businesses. For example, the pandemic has been terrible for tourism companies but great for food delivery and remote learning companies.
If you want to sleep soundly, it's wise to invest in multiple companies, not one. This risk mitigation strategy is called diversification, which is a fancy way of saying that itâs best not to put all your eggs in one basket. Diversification is a well-established tool for reducing investment risks.
The big problem for the small investor is that diversification requires a lot more money than buying a single company. For example, the average price for a single share of a company traded on the Canadian market is about $50. To diversify by investing in 10 companies would take $500, not $50. That math makes investment seem to be only for the wealthy.
Only for prosperous retirees?
I first owned stocks because I inherited some many years ago. Stock trading then was very expensive. You couldnât buy or sell shares directly. Instead you had to use a broker, who would charge you a $30 fee to make the trade for you.
Moreover, you couldnât just buy a couple of shares; you had to buy a 100! Thatâs because trades were done manually and were consequently restricted to 100-share lots. If a single share cost $50, you had to commit $5000 for 100 shares to invest in one company.
Under such conditions, creating a diversified basket of stocks, called a portfolio, required considerable wealth.
There was another drawback in those pre-internet days. Stock picking information was difficult to find. You had to rely on your brokerâs advice or spend hours reading newspaper business sections and financial magazines. Such sources were not plentiful where I grew up.
High costs and poor information access certainly discouraged stock investing. Perhaps thatâs why it was mostly an activity for prosperous retirees, who had both time and money. Have a lot of those resources? I didnât.
A few bucks and web access
Times have changed since the days when stock trading required lots of money and considerable time. Computers and the internet have made trading accessible to anyone with a little money and online access.
You no longer need a broker because you can make trades yourself online. Moreover, the cost of a trade is a few dollars or free. There is no 100-share requirement, so you can now buy as little as 1 share (or even fractional shares with some discount brokerage firms).
Reduced costs and trading flexibility mean that one can invest in stocks with a very modest amount of money. Inexpensive trading also makes it possible for the small investor to own a diversified basket of stocks.
As for information, the web has more stock-related information than you could ever use, mostly for free. For example, type the name of a company of interest, say Canadian National Rail, at Google Finance. All kinds of details about the company will be available, as the accompanying screenshot illustrates.
Procedural friction matters
In his famous Getting Things Done book David Allen describes how small sticking points create powerful barriers. A big fan of vertical files, Allen warns against a tiny detail, overfilled file folder drawers. An overfilled drawer makes it harder to slide a new page into its appropriate folder. Such friction increases the likelihood that youâll take the easier path of putting the paper on your desk instead. Your desk piles grow, disorganization ensues, and you get less done. One look at my file cabinet and my desk and I knew he was right.Â
Much of the procedural and expense friction that previously discouraged stock investing is gone. However, cheaper and easier trading didnât remove a second sticking point.
Diversification made easy
Diversification is much easier to understand than it is to implement. A key diversification problem is that it takes a lot of time to identify suitable companies and then to trade them. Exchange Traded Funds (ETFs) were invented in the 1990âs to solve that problem for the investor.
Many stocks disguised as one
An ETF is a stock that can be traded like any other. Whatâs different about an ETF is that a single share represents a basket of many other companiesâ stocks, from dozens to hundreds. The performance of the ETF stock reflects the combined performance of its constituent stocks â diversification.
ETFs are publicly traded and can be easily bought and sold through a brokerage account. To a great extent they have replaced mutual funds, which require a separate relationship with the mutual fund management. You only need a relationship with a brokerage account for an ETF and they typically have lower fees than mutual funds.Â
Many ETFs are designed to represent indices like the S&P 500. When you buy such an index ETF, youâre buying a composite of those 500 companies. Â
In the case of index ETFs managers donât have to pick companies, only adequately represent the index. Consequently, they can charge a very small management fee, less than 1% in many cases. More actively managed ETFs will have higher fees because the managers actually have to know something about picking stocks.
As a prospective ETF investor you would first need to identify your favored investment strategy. Then you could find an ETF that modeled your strategy, and buy it. Voila! Diversification and low transaction costs. Itâs little wonder that ETFs have become tremendously popular for investors.
But waitâŚETF checkmate for Expats?
Unfortunately for đşđ¸ expats, ETFs have some hidden, serious problems.
As an expat living abroad you probably donât have a đşđ¸ address. Without one, you probably wonât be able to open a đşđ¸ brokerage account. That, in turn, means that you canât buy a đşđ¸ ETF. Â
Of course you could buy a non-đşđ¸ ETF in the country where you live. But thereâs a potent tax-related reason for not buying a non-đşđ¸ ETF. Itâs called Form 8621.
The IRS treats ETFs with suspicion and heightened scrutiny. Their motivations are brought to life in Form 8621, which takes dozens of hours of your time to complete or hundreds of dollars in account costs for a single ETF every year! Â
If youâre a small investor, the 8621 tax-prep costs of owning a non-đşđ¸ ETF offset the low cost of an ETF and its diversification advantages. And youâll incur those tax-prep costs annually! If only you could create a clone of an ETF without triggering Form 8621. But wait! You can.
Disinterest provides an opportunity
Although the IRS treats foreign ETF ownership with suspicion and numbing forms, they don't treat the ownership of foreign common stocks the same way. Own a non-đşđ¸ common stock? The IRS yawns.
Of course one has to report income from individually owned stocks, đşđ¸ or foreign, but on the customary 1040 forms . Income from common stock ownership is treated the same by the IRS regardless of its country of origin (as long as that stock is not an ETF).
The implication of such tax treatment of stocks is this: you can clone a non-đşđ¸ ETF by buying the same stocks its managers buy. The income from those individually owned stocks wonât trigger the IRS scrutiny that the ETF would.
How to steal and cook an ETF recipe
Assemble your utensils
Find a brokerage account that trades on your countryâs major stock exchange and provides basic trading. Look for a low-cost broker because the transaction fees for buying and selling will be your only ongoing expense.
Online brokers usually have low fees, and some even provide free trades. Expect to make ~15 trades (buy or sell) per year, so an estimate of your annual cost would be 15 x the trading fee.
Plan your meal
After youâve opened and stocked your brokerage account with your investment funds, youâre ready to buy stocks.
Before you make a single trade, decide on your investment goals. For a good review of the major approaches to investing, check out this summary. Your choice will vary depending on your personal circumstances and temperament. Â
Framing your personal strategy in terms of an investment strategy (income, growth, etc) will also help you narrow your search for an ETF that has your goals.
Pick your recipeÂ
With your investment strategy in mind, google, best performing [insert strategy description] ETFs in [your country]. Restrict the time frame of your search to recent months so youâll get current information about candidate ETFs.Â
My search for a dividend ETF in Canada turned up this recent summary of 10 ETFs that have been successful in producing dividend income. Each ETFâs top 10 stocks are listed along with other summary details. ETFs typically list the 10 stocks theyâve invested the most in.Â
Some ETFs invest in 100âs of stocks and others invest in a few dozen. If your goal is to duplicate an ETFâs portfolio, itâs easier to clone an ETF that has a small number of companies. In such cases, their top 10 list will encompass a larger percentage of their entire investment. Of the listed ETFs, I chose the Vanguard ETF, which has 39 stocks.
Assemble your meal
Next I wanted to get a list of stocks for the Vanguard fund, which has the stock symbol VDY. I then googled, list of holdings for vdy etf, and found a list of its 25 largest holdings. Part of that listing, the top 10, is shown below.Â
Add the % weight column entries and you get 71.6%. In other words the VDY managers invested more than 70% of their assets in the 10 listed companies. A similar pattern can be found in many ETFs.Â
The implications are obvious. You can create a clone of an ETF by buying the same stocks the ETF managers do. In the case of VDY the top 10 stocks would capture more than 70% of the ETFâs value. Â
Were you to buy 15 or 20 companies you could capture a larger portion of the ETFâs recipe. Additional purchases would, however, add time and trading fees to your expenses. Your call.
The VDY managers allocated almost 4x more of their money to Royal Bank stock than to Suncor stock. That decision was surely based on their sophisticated models of past investment outcomes. You could certainly choose to do the same and allocate different amounts to different companies, butâŚ.
Predictive models based on the past donât always work as well in the future. For example, oil prices have skyrocketed due to Ukrainian events so future VDY weightings of Royal Bank and Suncor could be quite different. The precision of a 4.87% weighting as it applies to the unknowable future is illusory.
Itâs enough for me to know that the managers of a very successful ETF allocated 70% of their fundâs assets to 10 specific stocks. When creating my clone I wouldnât worry about the precise weightings, but would allocate 10% of my funds to each of the ETFâs top 10 picks.
Revisit your recipe yearly
You should revisit your chosen ETFâs list of stocks regularly. When you do, compare your list of purchased stocks to the latest list of the ETFâs holdings. You should sell the companies that drop off the list and buy their replacements. You may also need to adjust the number of shares for continuing stocks.
A good time to rebalance is mid-to-late December. The companies that drop off your ETFâs top-ten list are the ones to sell. Use the sale proceeds to buy the new companies that now appear on the top-10 list.
If you sell a stock for a loss, you can claim that loss for credit on your tax return. To do so, you need to make the sale before the IRSâ last day for year-end tax-loss selling, usually in the last week of December. For this reason, mid-December can be a good time to rebalance.
Final Thoughts
An ETF is a great investment diversification tool that is ill suited for đşđ¸ expats. However, an expat can easily find a suitable ETF and copy its recipe. With that recipe in hand you can then buy the same stocks the ETF does, and the IRS wonât care.
Until next time,
đşđ¸ Expat Advisor
Disclaimer
The content in my tweets, newsletter, and website is for informational purposes only. It is not intended to be investment, tax, or professional advice.
Before acting on this content you should consult a professional. References to third parties are not endorsements.Â
When you invest, your money is at risk, and you may lose some or all of your investment.
 Past performance is not a guarantee of future results. Historical returns, hypothetical returns, expected returns and images included in this content are for illustrative purposes only.Â