Understanding Claymore’s Advantaged ETFs

June 20, 2011

In a series of posts earlier this month, I tried to demystify the swap-based ETFs launched by Horizons last year. These funds use a type of derivative called a total return swap to get exposure to the companies in the S&P/TSX 60 or the S&P 500 without actually holding any of the stocks in these indexes.

The primary benefit of using the swap structure is that the investor does not get an annual tax bill for the dividends. Instead, all the growth compounds until the investor sells her units of the ETF, at which point it is taxed as a capital gain.

While the Horizons ETFs are the only ones in Canada using total return swaps, Claymore also offers a family of ETFs that use a rather complicated structure designed to make them more tax-efficient:

Claymore Global Monthly Advantaged Dividend (CYH)
Claymore Advantaged Canadian Bond (CAB)
Claymore Advantaged High Yield Bond (CHB)
Claymore Advantaged Short Duration High Income (CSD)
Claymore Advantaged Convertible Bond (CVD)

One step forward

Like swap-based ETFs, these Claymore funds give you exposure to a market index without actually holding the assets in that index. But rather than using swaps, the Advantaged ETFs use forward agreements.

The best way to explain this arrangement is with an example. Let’s use the Claymore Advantaged Canadian Bond ETF (CAB). When an investor buys units of this fund, Claymore uses the cash to assemble a portfolio of non-dividend-paying Canadian stocks. (Yes, stocks, even though this is a bond ETF.) This portfolio of stocks is called the “top fund.”

Claymore than sells these stocks to a counterparty—in this case, TD Bank—with the settlement to occur at a future date. The counterparty, in turn, sells these stocks short and uses the proceeds to purchase the bonds in the index. This portfolio of bonds is called the “bottom fund.” According to the terms of the forward agreement, the counterparty must then settle the deal by delivering the return of the bottom fund, net of fees, to Claymore, who distributes these returns to the CAB’s investors.

If your head isn’t spinning, you may have figured out that the returns of the top fund (the Canadian stocks) are actually irrelevant to the ETF investor. This is because the counterparty has both long and short positions in the stocks, so it is perfectly hedged. Therefore, the only market exposure in the bottom fund—and therefore the only returns it delivers to the CAB investor—comes from the bond portfolio.

What’s the Advantage?

Why structure an ETF like this? The answer is that the forward agreement allows Claymore to characterize the ETF’s returns as capital gains, rather than as bond interest or (in the case of the Claymore Global Monthly Advantaged Dividend ETF) foreign dividends. They can do this because, technically, the ETF’s returns are coming from buying and selling the  Canadian stocks in the top fund.

The potential tax savings here are significant: both interest and foreign dividends are fully taxed as income, while capital gains are taxed at only half your marginal rate.

Unlike Horizons’ swap-based ETFs, the Claymore ETFs pay monthly distributions, which makes them suitable for income-oriented investors. While the distributions are primarily treated as capital gains, some may also be characterized as return of capital (ROC). Because ROC is not taxable immediately, investors may think of it as tax-free income, but it’s not. ROC lowers the adjusted cost base of the ETF units, which will lead to capital gains in the future. So it’s best to think of ROC simply as a deferred capital gain.

Later this week, I’ll look at the costs and risks involved in the Advantaged ETFs and help you decide whether they have a place in your portfolio.

 

{ 14 comments… read them below or add one }

Juan June 20, 2011 at 9:16 am

This is very interesting. With yield rates so low sometimes I think people forget that pure yield isn’t everything and there are other ways to help increase portfolio returns.

Sean June 20, 2011 at 1:09 pm

Although tax advantaged, I think CAB overall returns have been lower than the plain vanilla XBB (I believe both track the same or similar indices). I’m sure the costs of all that swapping and has something to do with it!

I noticed both the Claymore “advantage” and BMO’s high income “call” ETFs have a very important similarity. The constant ROC of the former and conversion of capital to income of the latter keeps the NAV low thus inflating the yield. This can trap unwary investors focussed only on yield or taxes.

Canadian Couch Potato June 20, 2011 at 1:29 pm

@Sean: Remember that all ETF returns are reported before taxes. In 2010, XBB returned 6.4% versus 5.2% for CAB. However, for investors in a high tax bracket, the after-tax returns would have been much closer because CAB’s distributions were taxed at half the rate.

You’re right that the high yields on many ETFs can be misleading. That’s why it’s always important to focus of total after-tax returns and not yield.

Michel June 21, 2011 at 6:46 am

Don’t get me wrong, but it sounds a bit too complicated to me! Do we really need such convoluted structures?

J from Ottawa June 21, 2011 at 1:32 pm

@Michel: Agreed that sounds way too complicated.

You want to invest in bonds but you have found a way to call interest a capital gain! Why would that even be legal. Not much wonder there is little trust in the financial industry. I wonder if people buying these even realize how this all works?

DP June 21, 2011 at 4:00 pm

Great post Dan – thanks for taking the time to explain. These derivative-based ETFs seem to make a ton of sense from a tax standpoint, and do not seem overly complicated (and I’m new to this!)

Hopefully new products like these will gain broader acceptance in the Canadian market and thus encourage the manufacturers to continue to innovate and close the gap between the more extensive selection of ETFs available in the US and Europe.

One question: Does anyone know of a similar Bond ETF based on a forward agreement that DOES NOT pay monthly distributions? I’m looking for the something that behaves similar to the swap-based HXT and HST equity funds which eliminate all distributions and require capital gains tax to be paid only when the ETF is sold.

Canadian Couch Potato June 21, 2011 at 9:50 pm

@J From Ottawa: I think it’s important to stress that there is nothing illegal or deceptive about these ETFs. They have been used for years, and the structure is explained in the funds’ literature. However, I suspect you’re right that many investors who use these products do not understand them.

@DP: I am not aware of any bond ETF that does not pay distributions.

Sleepydoc June 27, 2011 at 5:25 pm

If the counterparty has to agree to return the performance of the underlying index, and infact owns the actual assets in the bottom fund…. Why then have some of these ETFs trialed their index by so much? You point out in the next article that CYH was off the mark by more than 1%!

Canadian Couch Potato July 1, 2011 at 4:36 pm

@Sleepydoc: Sorry for the delay in responding. The 1% tracking error can easily be explained by the management fee and the additional fee paid to the counterparty. Note also that, unlike a total return swap, the counterparty is not obligated to deliver the exact returns of the index itself. So if the bottom fund does not track the index perfectly, then that tracking error will be passed on to the investor.

D50-50 October 24, 2012 at 8:50 pm

Hi Cpp

great post, great blog

I noticed clf and cbo ishare bond ladders actually use return of capital distributions. Although not advertised, would these bond etfs be as tax efficient in a nonreg acct as these advantaged etfs?

Thanks!

Canadian Couch Potato October 24, 2012 at 9:57 pm

@D50: One should expect that the bulk of the distributions from CLF and CBO will be interest and therefore fully taxable. I think that iShares (formerly Claymore) will add a little return of capital if necessary to maintain a consistent monthly distribution. (They do this with their dividend ETFs as well.) But this quite different from what the Advantged ETFs do.

bobby December 30, 2012 at 10:06 pm

I have my RRSP with Fidelity.ca
Can anybody recommend which ones are there best mutual funds in terms of return ?

Thanks,
bobby

Vivian January 10, 2014 at 6:04 pm

With the termination of the forward-agreement structure in November 2013, it looks like CAB is now virtually identical to XBB? Even the MERs are identical now… http://ca.ishares.com/product_info/fund/overview/CAB.htm?fundSearch=true&qt=CAB
http://ca.ishares.com/product_info/fund/overview/XBB.htm?fundSearch=true&qt=XBB

Can someone with more expertise confirm this? I have holdings of CAB in my non-registered account – but will transfer them to my registered accounts if the distributions are going to be taxed like straight interest.

Canadian Couch Potato January 11, 2014 at 9:49 am

@Vivian: If you’re a CAB unitholder, I’d encourage you to contact iShares directly for an answer. That’s the only way to ensure getting accurate info.

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