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Is the Stock Market Too Concentrated?

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It probably doesn’t come as a surprise that Amazon, Netflix, Microsoft, Apple, Alphabet and Facebook have been some of the best performing stocks in the first half of this year. But what may be surprising is that those six stocks made up 98% of the S&P 500 Index returns for the first half of 2018 according to a recent CNBC article1!

Many headlines over the last year have pointed out just how large these tech giants have grown For the first time since 20002, the tech sector now represents 25% of the S&P 500. When viewed another way, the market capitalization- the amount investors have deemed the companies are worth of the top (largest) five companies is approximately equal to the bottom (smallest) 282 companies in the S&P 500, as illustrated by the amazing pie chart below created by Michael Batnick of Ritholtz Wealth Management3.

 

Weight of top 5 companies in S&P 500 versus bottom 282 companies

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In other words, the bottom 56% of the S&P 500 has the same market capitalization as the top 1%. That’s a lot of companies. Those 282 listed include many household names such as Chipotle, Kohl’s, Clorox and H&R Block, all of which are multi billion-dollar firms on their own. Which begs the question, is it typical for a handful of the largest companies to dominate an index?

It turns out that historically it’s not uncommon for the largest companies to represent an enormous percentage of the index. Today the largest 10 companies represent a little over 20% of the large cap space  That’s right about the average we’ve seen over the last few decades, and significantly lower than it was in the 1960s, according to a recent study by Travis Fairchild at O’Shaughnessy Asset Management4. This study also found that on average, about 6-7 of the top 10 names fall out of the top 10 within the following decade, suggesting that many of the current top ten companies will be replaced in the next ten years.

This phenomenon isn’t limited to just the U.S. According to Benjamin Felix of PWLCapital, through July 13th of this year, 75% of the S&P/TSX return came from just 10 of its 246 stocks, led by Suncor Energy, Toronto-Dominion Bank and Shopify5. This may lead you to ask, is there anything I should be doing as an investor to take advantage of this?

First off you should note that well diversified portfolios likely hold all the names mentioned in this piece; Amazon, Apple, TD, etc. are some of the largest holdings for most North American investors. But investing a portfolio solely in those largest companies has two pitfalls- undue concentration of risk and missed opportunities in other areas of the market.

The first pitfall of investing solely in individual names – even some of those red-hot tech stocks, came home to roost at the end of July. Both Facebook and Twitter reported earnings which fell short of market expectations. On July 26th, the day after their quarterly earnings announcement, Facebook fell by a whopping 19%, erasing $120 Billion USD in value! This amount is greater than the entire value of large companies like GE, Nike or Starbucks. A day later, following Twitter’s earnings announcement, that stock also fell 19%. Twitter had been one of the best performing stocks over the previous year prior to that announcement.

While these companies are included in most major stock market indexes, the performance of any individual company is going to be relatively small in comparison to the entire index- for example the S&P 500 was basically flat on July 26th, even with Facebook falling dramatically. But if you owned them individually- they would likely represent a far greater percentage of your overall assets.

Another major downside of only holding those largest of companies is missing out on large potential gains elsewhere. Small companies outperformed their large cap counterparts in the U.S. and Canada significantly over the second quarter of this year. And academic research shows that historically small companies have outperformed their large counterparts over decades6. Yet for the average investor, it’s difficult to not want to go all in on the large gains you’ve recently seen on familiar companies you likely interact with every day.

If outperforming were as easy as picking the recent winners and calling it a day, active fund managers would have a far better track record than they currently do. But as we’ll explore in a future blog, the record of both U.S. and Canadian active stock managers is poor, supporting the idea that it’s extremely difficult to outsmart the market and predict in advance who the winners of tomorrow will be.

Like the Apples or TDs of today, or the IBMs or Blackberrys of the past, a few large high-flying companies will often garner the headlines. Yet the key to reaching your financial goals is not the fool’s errand of trying to guess what the wonder company of tomorrow will be, but in keeping a well-diversified portfolio that will own all the companies that may provide that growth.

By Matthew Carvalho, Chief Investment Officer

1Just three stocks are responsible for most of the market’s gain this year, CNBC, Jul 10, 2018
https://www.cnbc.com/2018/07/10/amazon-netflix-and-microsoft-hold-most-of-the-markets-gain-in-2018.html

2S&P 500 Hits Tech-Heavy Milestone Last Seen With Dot-Com Bubble, Bloomberg, Feb 28, 2018
https://www.bloomberg.com/news/articles/2018-02-28/s-p-500-hits-tech-heavy-milestone-last-seen-amid-dot-com-bubble

3@michaelbatnick tweet, July 18, 2018
https://twitter.com/michaelbatnick/status/1019680856837849090/photo/1

4@tbfairchild tweet, Jun 6, 2018
https://twitter.com/tbfairchild/status/1004375185179529217

5@benjaminwfelix tweet, July 13, 2018
https://twitter.com/benjaminwfelix/status/1017869943226937345/photo/1

6 Common risk factors in the returns on stocks and bond, Journal of Financial Economics 1993, Fama and French

RRSP Withdrawal Tax Implications for Non-Residents

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From The Globe and Mail article:

Mr. Ritchie says he increasingly receives inquiries from well-to-do Canadian retirees who want to spend even more time at their homes in sunny Florida, California or Arizona than the rules allow…

Read the article here

RRSP Withdrawal Tax Implications for Non-Residents

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A large number of the clients that we work with are those that move from Canada to the United States. In these cases, we spend quite a bit of time making our clients aware of the income tax implications of leaving Canada and establishing tax residency in the U.S. We have written many publications on this topic, including a recent article, “Moving from Canada to the United States: What You Need to Know.”

For many of these people transitioning from Canada to the U.S., some of their larger financial assets are held within their registered plans (RRSPs, LIRAs, RRIFs, etc.). Given that our firm is properly registered and licensed in both Canada and the U.S., we can provide ongoing financial planning, tax and investment management for our clients who choose to leave their registered assets in Canada.

Summary and Takeaways

The article reviews the tax implications for Canadians moving to the United States, particularly concerning the withdrawal of funds from Registered Retirement Savings Plans (RRSPs). It highlights the firm’s experience in managing financial planning, tax, and investment for clients who retain their RRSPs in Canada, navigating both Canadian and U.S. tax systems. Tax withholding rates on RRSP withdrawals vary depending on the individual’s tax residency status and the amount withdrawn. For residents of Canada, the tax withheld ranges from 10% to 30%, whereas non-residents are generally subject to a 25% withholding rate, which can be reduced to 15% under specific conditions outlined in the Canada-U.S. Tax Treaty. The article emphasizes the importance of proper departure planning to ensure that the appropriate tax residency status is recorded to avoid unnecessary tax implications. Additionally, it mentions the potential for non-residents to file a Canadian income tax return under Section 217 in certain circumstances to benefit from Canadian tax deductions and credits.

Key Takeaways

  • Tax Implications for Canadians Moving to the U.S.: Awareness of income tax consequences is crucial for Canadians relocating to the U.S., especially regarding RRSP withdrawals.
  • RRSP Withdrawal Tax Withheld: Canadian residents face a sliding scale of withholding taxes on RRSP distributions, while non-residents typically see a 25% rate, adjustable to 15% under specific treaty conditions.
  • Importance of Accurate Tax Residency Status: Proper departure planning and documentation are vital to ensure the correct withholding tax rate is applied to RRSP distributions for non-residents.
  • Potential Tax Treaty Benefits: The Canada-U.S. Tax Treaty offers a reduced withholding tax rate on RRSP/RRIF distributions under certain criteria, highlighting the need for experienced, time-tested financial guidance.
  • Filing Under Section 217: In some cases, non-residents may file a Canadian income tax return to claim deductions and credits, potentially reducing the tax burden on RRSP withdrawals.
  • Canada-U.S. Investment Management: The firm’s capability to manage clients’ investments and retirement accounts with a thorough understanding of Canada/U.S. tax efficiency can significantly benefit those moving between the two countries.

By leaving these assets in Canada, continued tax deferral in Canada and most U.S. states will continue. The State of California, however, has a different set of tax rules that relate to registered plans that remain in Canada. See our article, “California Residents: Does Your Financial Advisor Tax-Manage Your RRSPs?”

As we develop our clients’ comprehensive Canada/U.S. financial plans, discussions and decisions with respect to taking distributions from their RRSPs for future lifestyle or retirement planning purposes are reviewed. For the vast majority of our clients, RRSPs continue to be managed by us through our Canadian institutional custodian until clients retire or are required to convert their RRSP to a RRIF.

However, what if one was looking to take a distribution from their RRSP as a non-resident of Canada prior to retirement, i.e. for the down payment on a new U.S. home or to meet current lifestyle requirements?

Let’s first review the tax impact of de-registering a Canadian RRSP before becoming a U.S. tax resident. As a resident of Canada, distributions from an RRSP are be subject to ordinary income tax rates depending on the province of tax residency. The bank or custodian holding the RRSP would be obligated to withhold tax upon the RRSP distribution at the following rates:

Withdrawal Amount % Federal Tax Withheld
From $0 to $5,000 10% (5% in Quebec)
From $5,001 to $15,000 20% (10% in Quebec)
Greater than $15,000 30% (15% in Quebec)

The withholding tax rates above would only be applied for those individuals who would still be considered tax residents of Canada. If one were to become a U.S. tax resident or non-resident of Canada, the Canadian withholding tax imposed on distributions would be 25%. Under Article XVIII(2) of the Canada-U.S. Tax Treaty, distributions from RRSPs/RRIFs can be reduced to 15% under certain and very specific guidelines. This would generally only be the case if one was to convert their RRSP to a RRIF and take periodic distributions from the RRIF. Under the Canada-U.S. Tax Treaty, this would include payments out of a RRIF where the total amount paid in the current year does not exceed twice the “minimum amount” and 10% of the value of the RRIF at the beginning of the tax year. The “minimum amount” is determined by a percentage factor based on the RRIF holder’s age at the beginning of the tax year.

Some Canadian financial advisors and individuals believe that the above table of withholding tax rates would be applied irrespective of Canadian and U.S. tax residency, which is incorrect. If the departure planning is done properly, then the Canadian institution should have the correct U.S. address on record and the tax residency indicated as a non-resident of Canada. This would generally be acknowledged by the bank or custodian via the completion of CRA Form NR301 and IRS W-9 form at the time the account becomes tagged as a non-resident of Canada account. Therefore, a 25% Canadian withholding tax would apply for lump-sum distributions.

If the individual or advisor still maintains a Canadian address on the account while claiming to no longer be a tax resident of Canada, they are opening themselves up for a number of issues. For example, the ability of an advisor to properly and legally manage registered accounts can be problematic, and so can the indication to CRA that Canadian residency is maintained (though the use of a Canadian address) when a previously filed Canadian tax return indicates a date of departure from Canada.

In some unique situations, former residents of Canada might be able to file a Canadian income tax return as a non-resident under Section 217. Filing a return under this election allows a non-resident to file a Canadian tax return if it would be beneficial for them to do so. In this case, the non-resident taxpayer would be able to claim the same deductions and credits as that of a traditional Canadian taxpayer. There are limited reasons for a non-resident to make this election. One reason is when an individual has a non-working spouse in the U.S. with, for example, $50,000 in their RRSP. In this case, the individual could withdraw the RRSP tax free over five  years without paying any Canadian income tax. Conversely, if the non-working spouse withdrew the $50,000 in a lump sum, there would be a 25% withholding tax imposed at the time of distribution.

As part of our comprehensive wealth management process, and based on our clients’ specific financial planning objectives, we can provide an RRSP distribution analysis to review the options available and the related Canada and U.S. income tax results. Further, because we manage our investment and retirement accounts on a Canada/U.S. tax-effective basis (we understand tax!), we can ensure that withholding tax paid in Canada can be recovered over time through proper portfolio and tax management.

 

 

Terry Ritchie featured in The Insurance & Investment Journal article, Managing Cross-Border Clients

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From the Insurance & Investment Journal article:

Managing cross-border clients is a challenging area for advisors that requires thorough knowledge on how to handle life insurance, investments, taxes and pensions while respecting two countries’ rules and regulations.

The Insurance and Investment Journal spoke to U.S-Canada cross-border expert Terry Ritchie, a director at Cardinal Point Wealth Management, who’s specialized in the field for more than 25 years to find some answers. He says if you don’t have knowledge or experience it is very easy to mess things up for your client.

Read the article here

Estate Disputes: Strategies for Keeping the Peace

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Estate planning issues can create family discord, especially in cases in which there is a sizable inheritance and heirs have disparate circumstances and competing interests.

“You seem to know people,” says Terry Ritchie, director of cross border wealth services with Cardinal Point Capital Management Inc. in Calgary, “but when someone dies and there’s money [involved], their real colours come through.”

Managing delicate family dynamics can be challenging, Ritchie adds, but there is much you can do as a financial advisor to prevent and minimize potential conflict. Ritchie offers the following advice for helping clients keep family peace before and during a wealth transfer:

Encourage open dialogue

Ritchie recommends hosting a family meeting that includes the client and all the beneficiaries of the estate as part of the estate planning process. Heirs who are unable to attend in person can connect by speaker phone or online. The conversation should cover how the wealth transfer will unfold and issues unique to that case that might arise.

As the financial advisor, you are in a position to address family members’ questions about the ins and outs of the wealth transfer. For example, you can field questions that may arise regarding taxes, which can complicate the process, especially if there are cross-border tax issues.

But the level of disclosure you get into — such as the client’s net worth and the distribution of assets — is your client’s call. Ritchie lets his clients decide whether it makes sense for him, as the advisor, to communicate with the family. Once he has the approval to engage the family, he is careful to treat the children equally and be up-front about how he’s helping their parents.

Improve your client knowledge

Expand the scope of your discovery process to include getting to know your clients’ family dynamics. Ritchie usually holds an in-depth conversation with clients about how their children are faring, asking if there are any issues he should be aware of that could complicate the wealth transfer.

For example, Ritchie becomes attuned to the marital status and financial circumstances of his clients’ children, which helps him get a better sense of their motivations. By becoming familiar with your clients’ children, you create an opportunity to continue a relationship with that generation.

“I have a pretty good understanding of the cast of characters I might be dealing with in the future,” Ritchie says. “Many advisors don’t go that deep.”

Take the heat

If your client feels caught in the middle of an intractable sibling rivalry over the inheritance, Ritchie says, help ease the stress by acting as an intermediary.

He has faced situations in which clients’ children want to dictate the terms of how and when the assets will be distributed. In one case, one sibling felt that the wealth was being divided unfairly, because others were receiving a larger portion to include their children.

In such cases, Ritchie will take on the role of “bad cop,” enforcing the client’s expressed wishes and explaining the reasons behind the decision.

When the children prove relentless in pushing for their preferences, he often tells his clients: “Don’t be the bad guy, let me be the bad guy.”