Claymore Advantaged ETFs: Costs and Risks

Monday’s post took a peek inside Claymore’s family of Advantaged ETFs, which use forward agreements to make them more tax-efficient. Today we’ll look at the costs and risks associated with these ETFs so you can decide whether they’re suitable for your index portfolio.

The ETFs have reasonably low management expense ratios, ranging from 0.32% for the Claymore Advantaged Canadian Bond (CAB) to 0.66% for the Claymore Global Monthly Advantaged Dividend (CYH). However, the forward agreement carries an additional fee of 0.50% that is paid to the counterparty.

This fee is not included in the MER, so the total cost of the Advantaged ETFs is between 0.82% and 1.16%. That’s very high for an ETF, of course, but those fees have to be considered in context. If you hold a traditional bond ETF in a non-registered account and you’re in a 45% tax bracket, then a 4% yield is cut to 2.2% by taxes. If that 4% yield were taxed as a capital gain at just 22.5%—and that is the whole point of the Advantaged ETFs—it would be reduced to 3.1%. Even after deducting another 50 basis points in fees, your net return would be 2.6%. That’s still more than you’d take home if the distributions were taxed as interest.

Several of the Advantaged ETFs also use currency hedging, which adds yet another expense that doesn’t show up in the MER. (Over the long run, Claymore estimates that hedging will cause a drag on returns of about –1%.) An exception is the Claymore Advantaged Short Duration High Income ETF (CSD) is also available in a USD-denominated version (CSD.U) if you prefer to hold high-yield bonds without currency hedging.

Assessing the risks

Whenever an ETF uses a non-traditional structure, an extra layer of risk is involved. In this case, the risk is that the counterparty will be unable to hold up its end of the bargain. But as we saw with the Horizons swap-based ETFs, this risk is quite limited.

First, the counterparty for the Advantaged ETFs is currently TD Bank, which is not likely to default on a small obligation like this. The chances are much higher that one or more of the bonds in CSD, CVD and CHB will default before the counterparty.

Second, even if the “bottom fund” (which is managed by the counterparty) goes bust, the ETF investors still have a claim on the Canadian stocks in the top fund. This means that the most investors could lose is difference in value between the two portfolios.

Finally, because ETFs are regulated like mutual funds, counterparty risk must be limited to 10% of the fund’s value. If Claymore ever finds itself in a position where the value of the forward agreement represents more than 10% of the fund’s assets, they have to rebalance the agreement.

Are these ETFs right for you?

In my opinion, the additional risks of the forward structure are not particularly worrisome. It seems highly unlikely that a chartered Canadian bank would fail to meet its obligation, and even if it did, the loss to investors would be minimal: a 10% loss is the absolute worst-case scenario.

My bigger concern is the high costs of the Advantaged ETFs, especially since some of the fees are not obvious to the investor. As always, the real cost of an index ETF shows up in the tracking error, so that’s the number to keep an eye on. Several of the Advantaged ETFs are too new to have a meaningful performance record, but in 2010 CYH returned 11.1% while its index returned 13.9%, for a significant tracking error of –2.7%. CAB, meanwhile, returned 5.2%, lagging its index by 1% and underperforming the comparable iShares DEX Universe Bond Index Fund (XBB) by 1.2%.

The Advantaged ETFs are only appropriate in taxable accounts. It is quite possible that, even with their added costs, they will generate higher after-tax returns than traditional ETFs whose distributions are interest or foreign dividends. The advantages are greatest when yields are big and you’re in a high tax bracket. If you use these funds in a tax-sheltered account, you’re paying higher fees and reaping no benefit. Traditional ETFs would almost certainly be a better choice for RRSPs and TFSAs.

21 Responses to Claymore Advantaged ETFs: Costs and Risks

  1. Slacker June 22, 2011 at 10:16 am #

    Sounds like it will only be profitable when you’re close to the highest tax bracket? (too lazy to punch in the math…)

  2. Canadian Couch Potato June 22, 2011 at 10:19 am #

    @Slacker: I think that’s a fair assessment. When I put that question to Claymore, they agreed that these make the most sense for high-net-worth investors with sizable non-registered accounts.

  3. Chris June 22, 2011 at 11:51 am #

    I own CAB, and the fee paid to the counter party was news to me.

    Looking at the prospectus, it says “up to 0.55% per annum in the case of Claymore
    Advantaged High Yield Bond ETF”. With a 3.3% return , you’d need to be taxed above 39% for this to save you money.

    I’m torn between sticking with CAB for the PACC, or moving back to XBB.

  4. Canadian Couch Potato June 22, 2011 at 11:58 am #

    @Chris: Did you choose CAB simply for the preauthorized contribution plan, or because of the tax efficiency?

  5. Chris June 22, 2011 at 12:55 pm #

    I chose it for both the ability to do pre-authorized contributions and tax efficiency (TFSA is full). “RBC Canadian Bond Index” is the cheapest bond mutual fund I’m aware of outside of e-series, but it’s only government bonds. For a true CAB/XBB equivalent in mutual funds, you’re paying the same kind of fees as CAB, without the tax advantage.

    I worked it out, and with trading fees I could still buy XBB 17 times in a year and come out ahead over owning CAB.

    I’ll likely sell CAB, buy XBB, then do my dollar-cost averaging in RBF563. I’d then roll that in to XBB when it hit a certain dollar amount. Rather inconvenient to do (and an embarrassing mistake).

  6. Canadian Couch Potato June 22, 2011 at 1:00 pm #

    @Chris: There are no mistakes, only learning opportunities. :) TD’s Canadian Bond Index Fund (the I series) has an MER of 0.81%, which is much higher than XBB, but depending on how often you contribute it may be cheaper overall than spending a lot on brokerage fees. It also has the corporate/government mix that RBF563 lacks.

  7. Dean June 22, 2011 at 1:17 pm #

    Let me get this straight. These funds are good for you if:

    1) You are in the highest tax bracket or nearly there
    2) You have maxed out your TFSA AND RSP
    3) You cannot swap/trade the equities in your TFSA-RSP for income securities in your non registered account(s)
    4) You willing to accept chronic underperformance due to costs
    5) You are willing to pay the high MER

    I looked and looked but could find no Canuck to match this description. Do you know of any? I guess they’ve all gone to Vancouver.

  8. Canadian Couch Potato June 22, 2011 at 1:41 pm #

    @Dean: I don’t think you’ve been fair here. First, most invested money is held outside tax-sheltered accounts in Canada, so a lot of people satisfy points 1 and 2. Second, “chronic underperformance” and the higher MERs have to be looked at on an after-tax basis.

    For some investors, Fund A might deliver higher pre-tax returns than Fund B, but Fund B may allow them to keep more after taxes. That’s not underperformance. Similarly, if you pay $60 to save $100 in tax (or whatever it happens to be), that’s a $40 savings not an added expense. Individual investors will need to do the math to assess whether they would come out ahead, but you can’t look only at the cost without weighing the potential benefits.

  9. Eric June 22, 2011 at 2:17 pm #

    Total returns for CYH (1 year as of 05/31) is 28.6%, 1% less than CVY & HGI (29.8%). The index is 41% CVY & 59% HGI. It tracks its index closely.This is a unique product in Canada: Multi-asset, 3.9% yield and value stocks. But from what I understand, I should buy the US ETFs ? CYH is in my RSP.

  10. Canadian Couch Potato June 22, 2011 at 2:23 pm #

    @Eric: Remember that if you hold CVY or HGI you will be subject to currency fluctuations, so you will not get those published returns (which are in US dollars).

  11. Eric June 22, 2011 at 3:58 pm #

    I know it will be in USD but I won’t have all those hiddden fees. Why these are not included in the MER ?

  12. Michael June 22, 2011 at 5:36 pm #

    CAB also seems great for anyone with a large capital loss backlog. All the capital gains paid would be offset and effectively tax free.

  13. My Own Advisor June 23, 2011 at 3:27 pm #

    Great information.

    Because I’m trying to index almost everything in my RRSP at dirt-low costs, minimal tracking errors, I don’t see how CYH or CAB is a big benefit for me over more traditional ETFs; I won’t be buying these guys. I’ll stick to other income products in my RRSP, such as XBB and CLF.

    On that note Dan, is there such an animal anymore, “traditional ETFs”? In some ways, ETFs are on the fast track to becoming the new mutual fund.

  14. Canadian Couch Potato June 23, 2011 at 4:02 pm #

    @MOA: It’s true, traditional ETFs (by which I mean tied to third-party, cap-weighted indexes designed to track broad asset classes) have become outnumbered by the new kids. Some innovations have been good for investors, but it’s becoming awfully difficult to separate the wheat from the chaff.

  15. Ryan June 26, 2011 at 12:01 pm #

    You have CYH listed in your model portfolio for income based investors but say “this makes the most sense for high-net-worth investors with sizable non-registered accounts.” What about income investors that don’t meet this profile?

    I tried to make my own income portfolio using ETF’s that are hedged to C$. What do you think?

    XDV
    ZDJ
    ZDM
    ZEM
    ZRE
    +fixed income

  16. Canadian Couch Potato June 26, 2011 at 2:04 pm #

    @Ryan: The key idea is that the Advantaged ETFs make the most sense in non-registered accounts, so as an income investor I’ll assume you fit that description. You don’t need to be wealthy, of course: it’s just that the higher your tax bracket, the greater your savings. They don’t make a lot of sense in an RRSP.

    The portfolio you list here looks great — it’s very similar to the Complete Couch Potato. You’ve got all the important asset classes covered. Good luck!

  17. Ryan June 26, 2011 at 4:57 pm #

    I like the diversity of the Complete Couch Potato, but want to switch the ETF’s you have listed for dividend payers. I could revise my above portfolio for an un-registered account to:
    XDV
    CYH
    ZRE
    fixed income

    Would this be a more tax-efficient portfolio than what I have above? I don’t know how the international dividend payers are taxed.

  18. Canadian Couch Potato June 26, 2011 at 6:11 pm #

    @Ryan: These three funds are part of my Yield Hungry Couch Potato and would indeed be appropriate for an income investor in an unregistered account. CYH should be more tax-efficient than the international BMO funds you mentioned because foreign dividends are fully taxed as income, while CYH’s distributions are return of capital and capital gains.

  19. Ryan June 26, 2011 at 7:28 pm #

    Thanks for the help! Why is the international equity component of the Yield Hungry Potato component so small?

  20. Canadian Couch Potato June 26, 2011 at 8:10 pm #

    @Ryan: Canadian dividend stocks are still the best way to get tax-advantaged income on the equity side. But these allocations are not written in stone. Feel free to adjust them as you see fit.

  21. Andrew F July 14, 2011 at 12:38 pm #

    If I’m not mistaken, a bond fund has to distribute the coupon value as ‘other income’, so even though a portfolio might have a yield to maturity of 3%, if the average coupon is 4.5%, you’ll pay tax on 4.5% at the full marginal rate and get a capital loss of about 1.5% as the NAV declines. Thus, avoiding full-freight tax on a coupon rate that is significantly higher than the YTM can help make this swap structure attractive, even for investors facing a lower MTR.

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