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.