How Claymore’s Advantaged ETFs Pay Investors

In a previous post, I looked at some strategies for tax-efficient investing with ETFs. Among the innovative products designed for non-registered accounts are Claymore’s Advantaged ETFs, which hold either bonds or foreign equities. Because interest and foreign dividends are taxed at your full marginal rate, these ETFs use forward contracts to recharacterize all distributions as either return of capital (ROC) or as capital gains. Although there are costs and some added risks, these products may deliver higher after-tax returns than plain vanilla ETFs in the same asset classes.

What was never clear to me was why the distributions came in these two different flavours. In 2010, for example, the Claymore Global Monthly Advantaged Dividend (CYH) paid out $0.67 per share in distributions, virtually all of which was capital gains. Last year, however, the fund’s $0.63 per share distributions were all return of capital. I asked Claymore to clarify and Dan Rubin, vice president of marketing, replied as follows:

“The distributions in any given year will depend on the activity of the flows of the fund and the performance of the Canadian equities held by the ETF as part of the structure.

“For example, when the fund pays distributions it needs to sell a portion of the Canadian equities to raise the cash, and in years when markets have positive performance those positions will be sold at higher prices than they were acquired, and thus trigger capital gains. The opposite is true in years when markets have negative performance.

“Also, in some years, even though the markets can have positive performance, the fund might have accumulated losses from previous years which can be used to offset the losses in the current year.”

In other words, during years when Canadian equities are down, the Advantaged ETFs are likely to pay their distributions as ROC—which is what happened in 2011. When Canadian stocks are up, the ETFs are more likely to distribute capital gains, though these may be partially offset by past losses that have accumulated in the fund.

It’s interesting to note that the Claymore Advantaged Bond (CAB) and the Claymore Advantaged High Yield Bond (CHB) also benefitted from the negative return on Canadian equities in 2011. Although these ETFs track bond indexes, they actually hold Canadian equities as part of the forward structure. (See this post for an explanation.) As a result, the distributions of these funds were ROC last year as well, which means investors in these ETFs would have had zero tax payable in 2011. Call it a silver lining in an otherwise bad year for Canadian equities.

14 Responses to How Claymore’s Advantaged ETFs Pay Investors

  1. Michel February 6, 2012 at 3:45 pm #

    Interesting. I presume these funds will continue after the merger with Ishares. My ETF’s are with BMO and Ishares. Do they have such funds? Do you recommend these tax-efficient funds and most of all, at what cost? When does it start making a real difference? Thanks for your always “matter of fact” articles.

  2. Canadian Couch Potato February 6, 2012 at 3:57 pm #

    @Michel: iShares and BMO have no funds that use this type of structure. I would certainly consider them for a taxable account, though I would want to monitor them closely to see if the added costs overwhelm the tax benefits. For example, CAB trailed comparable plain vanilla bond ETFs considerably last year on a pre-tax basis. The forward agreement adds at least another 50 basis points to the costs, which is not reflected in the MER.

  3. james February 6, 2012 at 10:49 pm #

    Where can I find a copy of ‘ Building the Perfect Portfolio’?

  4. Canadian Couch Potato February 7, 2012 at 1:12 am #

    @James: Thanks for your interest in the book. You’re unlikely to find it in stores now, so the best way to get it is online at http://www.moneysense.ca/perfect

  5. Michael February 7, 2012 at 12:04 pm #

    Is there really any advantage one way or the other between Capital Gains and ROC? It seems to me that ROC takes a bit more book keeping (to lower your adjusted cost base) but it does defer the tax until you sell….

  6. Canadian Couch Potato February 7, 2012 at 12:10 pm #

    @Michael: As you say, the ROC will ultimately be taxable as a capital gain, but there is value in the deferral. At a future date you may be able to harvest other losses and use these to offset the gains.

  7. Adam February 7, 2012 at 12:27 pm #

    A great Follow up to your previous post on these more compex ETF structures. I wasn’t aware that the MER listed for CAB was before the cost of the forward structure. 50 basis points is a significant change to a fund with an MER of 0.32% and a YTM of 2.29%. Is there anywhere that an investor can easily find the “all in cost”? That is without having to try to reconcile past returns to the underlying index. Is this incremental cost also true for swap based ETFs like HXT?

  8. Canadian Couch Potato February 7, 2012 at 12:46 pm #

    @Adam: The most meaningful measure of the all-in cost is the fund’s tracking error. In 2010, CAB lagged its index by a full percentage point (5.2% return versus 6.2% for the index). So that’s 68 basis points not accounted for after the MER. (2011 reports will be available next month.)

    With HXT, there is no cost for the swap: either Horizons is eating it, or the counterparty is able to deliver the returns of the index and still make a profit. The tracking error of HXT has been outstanding: about -0.08% due to the MER and nothing else. With HXS, there is a fee of 0.40% for the swap on top of the 0.17% MER, for a total of 0.57%.

  9. Andrew F February 8, 2012 at 10:35 am #

    CAB has a low yield, so the cost of the forward structure seems outsized in relation to the tax saving. I have written off CAB for taxable accounts, at least until/if yields rise back over 4 or 5%. CHB (and CSD) is more interesting, given that there is more interest income spun off, making the cost of the forward smaller relative to the income.

    I’ll wait to see a full year for each of CSD and CHB relative to their non-forward counterparts to see what kind of drag one can expect from the fund expenses. I was shocked at the underperformance of CAB. Claymore has some explaining to do.

  10. Canadian Couch Potato February 8, 2012 at 10:48 am #

    @Andrew F: It’s certainly true that the Advantaged products would be more useful for high-yielding assets, so CSD and CHB look potentially more attractive than CAB. But as you say, it’s all in the execution. If CAB lags a fund like XBB significantly, the tax savings could be wiped out, and that may have been the case in 2011. Please let us know if your analysis turns up anything interesting.

  11. Andrew F February 8, 2012 at 11:06 am #

    If CAB trailed by just the extra 50 bpp for the forward, it would be worthwhile for any fund with a coupon/NAV of 2.17% for someone in Ontario’s highest tax bracket (assuming all capital gains and no value in the deferral of tax with ROC). Unfortunately, if it underperforms by a full 100 bpp, for someone making $70k in Ontario, a fund would need to have a coupon/NAV of a bit over 6%. It seems like there is some execution risk here, since we don’t know why CAB underperformed more than can be explained by the forward.

  12. Nathan October 10, 2012 at 4:26 am #

    Interesting point regarding ROC in market down years and capital gains in up years. That effectively improves its diversification benefit with the equities in your portfolio, one of the main goals of the fixed income portion.

    That said, CAB shows a weighted average coupon of 4.07% and a YTM (for the index) of 2.23%. So does it have the same problem as all other bond funds holding premium bonds; that the distributions are going to be greater than the YTM? The problem would be mitigated somewhat by the conversion to capital gains, but you’re still trading capital gains now for capital losses later, the opposite of deferral. It seems to me that in a taxable account one might be better served by a ladder of government bonds – after the savings of MER and counterparty fees, and the elimination of this extra tax on the coupons, you might be able to get the same after tax returns while eliminating the credit and counterparty risks of this fund.

    Sadly TD Waterhouse is in the middle of its mind boggling nightly multi-hour maintenance period, so at the moment I can’t see what kind of yields are available… 😛

  13. paj January 9, 2013 at 4:29 pm #

    Nathan, unfortunately i don’t think a ladder of bonds works either because unlike stocks, when you buy an individual bond there is a built in commission that can’t be avoided or even disclosed, but all the discount brokerage firms have it. That’s why for my bond portion of my portfolio I only buy bond etfs.

  14. Nathan January 9, 2013 at 5:09 pm #

    Certainly, there are disadvantages to buying bonds directly too. To get decent rates you need to invest a large amount of money in each bond, for one thing. As I’ve looked into it more, it looks like in most situations a 5 year GIC ladder is actually a much better deal. CDIC-backed GICs are just as riskless as gov bonds, don’t have any commission to buy or sell, and pay better (especially if you shop around). Yes the money is locked up, but for a couch potato, that’s not really a problem.

    Of course, in a TFSA, nothing else can even come close to the 3% offered by People’s Trust. Fully CDIC insured and zero interest rate risk.

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