My last newsletter explained how IRS rules make the popular ETF investment tool too pricey for most 🇺🇸expats. This week, I’ll explain how you can bypass this IRS constraint.
Assemble your utensils
Find a brokerage account that trades on your country’s 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 you’ve opened and stocked your brokerage account with your investment funds, you’re 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 you’ll get current information about candidate ETFs.Â
My search for a dividend ETF in Canada turned up a summary of 10 ETFs that have been successful in producing dividend income. Each ETF’s top 10 stocks are listed along with other summary details. ETFs typically list the 10 stocks they’ve invested the most in.Â
Some ETFs invest in 100’s of stocks and others invest in a few dozen. If your goal is to duplicate an ETF’s portfolio, it’s easier to clone an ETF that has a small number of companies. In such cases, their top 10 list will usually 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 ETF’s value. Â
Were you to buy 15 or 20 companies you could capture a larger portion of the ETF’s 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, but….
Predictive models based on the past don’t 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.
It’s enough for me to know that the managers of a very successful ETF allocated 70% of their fund’s assets to 10 specific stocks. When creating my clone I wouldn’t worry about the precise weightings, but would allocate 10% of my funds to each of the ETF’s top 10 picks.
Revisit your recipe yearly
You should revisit your chosen ETF’s list of stocks regularly. When you do, compare your list of purchased stocks to the latest list of the ETF’s 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 ETF’s 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 IRS’ 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 🇺🇸 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 won’t require the dreaded Form 8621.