If your portfolio loses 1% today and gains 1% tomorrow, are you back to even? Not quite, but you’re awfully close. You actually need a gain of 1.01% to get back to where you started.

While that difference seems trivial, it gets magnified when the ups and down of your portfolio get larger. A loss of 5% requires a 5.26% gain to recover, while a 20% loss needs 25%. As for a 50% drawdown like we saw in 2008–09, well, that’s even worse than it appears. Your portfolio needs to double (a 100% gain) to return to its starting value. Stocks do recover from devastating declines like this, but it can take many years: the Canadian and US markets are still well below their 2007–08 highs.

Some investors simply don’t have the ability or the stomach to endure drawdowns of 20% or more. As index investors all know, the most straightforward way to protect your portfolio from catastrophic loss is to adjust its asset allocation: a 50-50 mix of Canadian stocks and government bonds lost just 12% in 2008.

But as I wrote about last week, markets are filled with uncertainty. We simply don’t know how far stocks can fall, nor can we be certain that bonds will be there to catch them. That’s why some index investors look for ways to build a floor under their portfolio.

Exploring your options

One way to set a limit on your portfolio’s losses is to buy put options. A put gives you the right to sell an asset—such as a popular ETF—at a certain price within a specified period. Here’s an example that was kindly provided by Alan Fustey of Index Wealth Management, the author of Risk, Financial Markets & You. (These prices were accurate as of May 1, but they will change with market conditions.)

• You purchase the iShares S&P/TSX 60 Index Fund (XIU) at $17.60.
• You also purchase put options with a strike price of $17.00, expiring in six months.
• These puts cost you $0.62 per share.

With this strategy, no matter how far markets may fall in the next six months, you can’t lose more than 6.9%. Here’s why:

• If XIU has declined below the strike price when the options expire, you have the right to sell your shares for $17. Since they were originally trading at $17.60, that works out to a maximum loss of 3.4%.
• You also need to account for the premium you paid for the puts. At $0.62 per share, that’s an additional loss of 3.5%.

As you’ve probably figured out, this protection is not free. Remember that the cost of the options will reduce your return by 3.5% no matter what happens. The value of XIU needs to increase by 3.5% for you to break even, and if markets go up by 10% you’d get only 6.5%. (Note that we’ve ignored dividends here to keep things simple. With XIU you can add about a 1% dividend every six months.)

Calls for help

Clearly protective puts, as they’re called, are an expensive insurance policy. One way to lower the cost is to also sell call options on your ETF. A call gives the holder the right to buy an asset at a certain price within a specified period. You sell (or “write”) calls in order to earn income from the premiums. Here’s another example from Fustey to illustrate this strategy, which is called a collar. Again, prices were accurate as of May 1.

• You buy the iShares S&P/TSX 60 Index Fund (XIU) at $17.60.
• You purchase put options with a strike price of $17.00, expiring in six months, at a cost of $0.62 per share.
• You also sell call options with a strike price of $18.50, collecting a premium of $0.30 per share.
• Your net cost for the options works out to just $0.32 per share, or 1.7% of original value of XIU, about half what you paid for the puts alone.

Now the maximum loss you can suffer is just –5.2%. But with this strategy you limit your upside even further. If the price of XIU rises above $18.50 (about a 5% gain), the holder of the call options will buy the ETF shares from you at the strike price. You’d get the 5% gain, but no more. And once you factor in the 1.7% cost of the options, you’re guaranteeing that your maximum return over the six months will be 3.3% (plus any dividends).

Weighing the costs

There are a number of other ways to combine options strategies with index investing in order to limit catastrophic drawdowns and to generate additional income. When properly managed, they may be appropriate for investors who understand the trade-off. But while that trade-off may seem small when markets are trending down or sputtering along with single-digit returns, it won’t always seem so comforting. Investors will feel pangs of regret when they get left behind by a market surge like the one that began last October (US markets are up about 25% since then). As Fustey explains: “There is no free lunch that allows an investor to receive complete protection against loss without either an outlay of cash or capping upside return potential.”

For investors who are still in the accumulation stage—who have lots of time to recover from losses and no need to generate income—a traditional asset allocation strategy is likely to be far more efficient.

Tracking error—the difference between the performance of a fund and that of its benchmark—is the best way to measure an index fund’s true cost. While many investors focus on MERs, a low fee means little if an ETF lags its index by an additional 30 or 40 basis points.

A couple of weeks ago, I reported on the tracking errors of iShares ETFs in 2011, which were mostly very low. Today let’s look at the 2011 performance of the most popular ETFs that formerly bore the Claymore name, all of which were recently rebranded as iShares.

Let’s start with the positive results: the three core equity funds tracking the RAFI fundamental indexes had very low tracking errors. The Canadian Fundamental (CRQ) and the non-hedged version of the US Fundamental (CLU.C) both lagged by less than their MERs, which is always impressive. The International Fundamental (CIE) didn’t fare quite as well, but the higher costs of trading international equities makes this unsurprising.

Once again, currency hedging proved to be a major drag on performance: the hedged version of the US Fundamental (CLU) had a tracking error 60 basis points higher than that of CLU.C. Remember that this added friction will be there whether the Canadian dollar rises or falls during the year.

The performance of both CLU.C and CIE are very encouraging, given that both funds have experienced terrible tracking errors in the past. I currently recommend the US-listed PowerShares fundamental ETFs in my Über-Tuber portfolio because of this poor track record. But now that these funds hold all of the stocks in their indexes (as opposed to a representative sample, as in years past) they seem to be doing an excellent job of mirroring their benchmarks. Next time I update the model portfolios I will have to consider including CLU.C and CIE.

Not such an advantage

The Claymore/iShares Advantaged ETFs, which hold either bonds or foreign dividend paying stocks, are designed to be as tax-efficient as possible. I include three of them in my Yield-Hungry Couch Potato, which is designed for non-registered accounts.

The performance of these funds was mixed. The Global Monthly Advantaged Dividend (CYH) actually had a higher return than its benchmark, which is a pleasant surprise. But the Advantaged Canadian Bond (CAB) and the Advantaged U.S. High Yield Bond (CHB) lagged their indexes by 2.1% and 1.8%, respectively.

The Advantaged funds have higher expenses and should be expected to have bigger tracking errors than their plain-vanilla counterparts—even then the tax advantages might still put them ahead. But for investors who are not in the highest tax bracket, the “advantage” is likely to be slim to zero when tracking errors are this high. The comparable iShares DEX Universe Bond (XBB) returned 9.36% in 2011, while the iShares U.S. High Yield Bond (XHY) returned 6.83%. It’s quite possible the after-tax returns on these traditional ETFs may have been higher for investors who were not in the highest tax brackets.

I consider these Advantaged bond funds to be on probation: if they continue to lag like this, I will remove them from my model portfolio.

Back in January, BlackRock—the parent company of iShares—announced that it had acquired Claymore Investments, the second-largest ETF provider in Canada. Since then, BlackRock has been gradually integrating the former Claymore funds into its family. The ETFs were officially rebranded last week and all of them now trade under the iShares name.

Many readers have wondered about what this acquisition will mean for individual ETF investors. On Monday, I had an opportunity to sit down with Mary Anne Wiley, the newly named Head of iShares for BlackRock Canada. Here’s part of our interview—more to come later in the week.

I was surprised when I first heard about the acquisition, but after a bit of reflection, it was clear that the two ETF families actually had very little overlap.

MAW: I think that was the reaction of most people: “I never saw that coming.” But then they took a step back and realized that it made a huge amount of good sense for us, and for the market at large. We have one of the most trusted brands in ETFs, and Claymore had done a really nice job of building a platform that was where iShares was not. They were very smart in building their business.

We had always focused on cap-weighted equities and fixed income based on the DEX benchmarks, whereas Claymore’s equity lineup was not cap-weighted, but rather fundamental indexes. They had also been very creative in the way they built out their bond exposures with the traditional laddered approach, which was very appealing, particularly to advisors. And they have done a great job in the commodity space. So at the end of the day there was almost no overlap.

Does that mean there will be no fund closures?

MAW: We have just announced the closure of one fund: the inverse bond ETF. When we looked at the product lineup and started to make our decisions, there were three criteria we used. The first was whether there was a long-term sustainable place for the ETF in the market. That doesn’t mean it has to be buy-and-hold-forever, but we are not looking for the hottest thing that is going to sell a lot today but have no longer-term appeal. Second, it had to be something unique or additive: there needs to be something that differentiates it from what is already available. The third was that it had to be consistent with the iShares brand, and what we stand for. And we don’t do inverse. That product was designed to be very short-term; it’s speculative. And the market hasn’t really embraced it. So as a result, we announced that fund would be closing.

But outside of that, we have come out and said we are going to continue to promote the Advisor Class ETFs, which is new for iShares. The laddered bond ETFs, the RAFI indexes, the commodities—we are supporting all of these other families of products, which hopefully confirms that we stand behind what we said, that these are a great complement.

That said, there is a little bit of redundancy in the two families, and I think the most obvious is CWO and XEM, which both invest in broad emerging markets, and according to your website, both track the same index. Will we see these funds merged?

MAW: If we go back to the three criteria I talked about earlier, I think we all agree that emerging markets has long-term sustainable merit. So, are the two products unique? Their holdings today are actually different, and we want to make sure that going forward they are sufficiently different. If not, then we would consider merging them. I don’t have the answer for you today, but it might make sense to take CWO and convert it to a RAFI strategy. That is one of the things we’re looking at doing.

Another example that I have been asked about are the two dividend funds: XDV and CDZ. They are quite different, but at first blush, they are going after the same segment of the market. XDV is focused on dividend yield, while CDZ is focused on dividend growth. So the composition is different, and an investor can actually make a decision on whether one makes more sense than the other. That is another instance where we will support both, because there is a market for both.

How does this affect your plans to launch your own new products? I know you already had a number of your own new products in the pipeline. Now that you have just added dozens of new ETFs, will these be delayed?

MAW:  No, not at all. There will be new products. The iShares brand now has new products because of the acquisition, but the marketplace doesn’t. There are still needs that haven’t gone away, and we want to be the player who meets those evolving needs. I don’t think the world needs another large-cap Canadian equity ETF: that’s covered. But there are strategies and segments of the market that are appearing in the ETF space, and we want to be the provider that brings them out. As long as they are additive, and there is a long term place for them in the market, and that they’re consistent with the iShares brand.

It’s report card time in the investment fund world. Every year at this time, all mutual funds and ETFs are required to file a Management Report of Fund Performance, a document that contains a wealth of useful information. (They’re available from the SEDAR website.) If you’re an index investor, one of the most important things you can learn is a fund’s tracking error.

Tracking error is the difference between the performance of the fund’s underlying index and that of the fund itself. Remember, the goal of an index fund is to deliver the returns of a particular asset class, as measured by an index. If a fund does a consistently poor job of that, it’s time to start looking for another option.

iShares released its MRFPs yesterday, and I looked up the tracking errors for a number of their most popular ETFs:

Sizing up the performance

Canadian equities: You should expect a Canadian equity index fund’s tracking error to be about as large as its MER—perhaps a few basis points more. The iShares ETFs have exceeded expectations here: XIC, XIU, XMD and XCS all have tracking errors lower than their annual fees. That means the fund managers not only tracked the indexes perfectly, they even managed to add a little value, probably through activities such as securities lending and arbitrage. This is top-shelf performance.

US equities: Tracking foreign equities is always more difficult due to withholding taxes. But it’s currency hedging that creates the biggest drag on fund’s like XSP.  The fund’s tracking error was –0.64%, despite an annual fee of just 0.25%. But there’s more: XSP’s index accounts for the currency hedging strategy, which is reset each month, and this index returned 1.71%. However, the S&P 500’s actual return in US dollars was 2.11% last year. So the true underperformance of XSP was –1.04%. Over the last seven years, this performance gap has averaged more than 2%. This is why I don’t recommend currency hedging. (Note that the two international iShares ETFs that do not use hedging—XEM and XWD—both had tracking errors lower than their MERs.)

Fixed income: The two largest bond funds, XBB and XSB, also had tracking errors lower than their MERs, another excellent result. The corporate bond ETFs did not make out so well. It is actually much more difficult to track a corporate bond index than many investors realize. As a result, XCB’s tracking error has averaged –0.82% over the last five years, despite an MER of 0.42%. XIG, which tracks US investment-grade corporates with currency hedging added, shows a huge tracking error of –1.45%, but it outperformed its underlying ETF in US dollar terms (10.40% versus 8.89%). I admit that one has me baffled.

I’ll have more tracking error reports to share next week when all the documents are available.

BlackRock surprised almost everyone in January by announcing that it would be buying Claymore Investments, the second-largest ETF provider in Canada. The move takes another step forward today when the former Claymore ETFs start trading with new names. With a couple of exceptions, all of the Claymore exchange-traded products have been rebranded with the iShares name. The Claymore website has been taken down and all links now take you right to the iShares site.

If you’re an investor who owns any of these ETFs, you should notice the name change when you log in to your brokerage account, but the ticker symbols will remain the same. iShares has also pledged to honour any existing preauthorized cash contributions (PACCs) and distribution reinvestment plans (DRIPs). Claymore pioneered the PACC plans several years ago in an effort to eliminate one advantage that mutual funds still have over ETFs, and both Horizons and XTF Capital have since followed suit.

Whether iShares plans to eventually extend the PACC program to all of its ETFs is one of several unanswered questions. Another surrounds Claymore’s “Advisor Class” ETFs, which charge an additional trailer fee. iShares has never offered such versions of their own ETFs, but they will retain the Advisor Class versions of the former Claymore funds.

The big questions, of course, are whether there will be fee changes or fund closures. The answer to both questions is no, at least in the short term. When I first wrote about the acquisition in January, many readers expressed concern that eliminating a competitor would open the door for BlackRock to hike its fees, but I would be shocked if this happened. With Vanguard now on the scene, any ETF provider that starts raising fees is going to see a flood of redemptions. It makes no sense as a corporate strategy, and BlackRock knows that.

BlackRock has also said that it has no immediate plans to close or merge any ETFs. It’s actually quite remarkable how little overlap there is among the 83 funds now in the iShares lineup. The axe may fall on a few of them eventually, but there really are no obvious candidates.

One of the problems with actively managed mutual funds is that you can never be sure that the risk level will remain constant. In an income fund with a mix of government bonds, high-yield corporate bonds and dividend-paying stocks, for example, the exposure to these asset classes can vary according to the manager’s whims. Well, it turns out that same is true of some ETFs.

The iShares Diversified Monthly Income Fund (XTR) uses several other iShares ETFs to offer a blend of “income-bearing asset classes, including, but not limited to, common equities, fixed income securities and real estate investment trusts.” The fund’s web page makes it clear that “BlackRock Canada will review, and may adjust, XTR’s strategic asset allocation from time to time, as market conditions change.” However, in practice, the fund’s asset mix has remained virtually unchanged since its launch in August 2010.

But not anymore. XTR recently made a big shift that has significantly changed its risk profile (hat tip to reader Alec P. for pointing this out). Here’s how the fund’s holdings have changed:

A major shift

The biggest change is a doubling of the exposure to high-yield bonds (via XHY and XHB), from 18% to more than 37%. The allocation to government bonds, meanwhile, has fallen from more than 17% to just 3%. The fixed income side of the portfolio is clearly a lot riskier than it had been for the last 18 months or so.

The greater allocation to high-yield bonds is offset somewhat by the lower allocation to equities, which has fallen from over 55% to less than 40%. By dropping XIU (which has about 34% in banks and less than 1% in utilities) and adding a 10% allocation to XUT, the portfolio now has a dramatically different mix of sectors, too. Reducing the holding of XDV (55% financials) and adding XEI (31% financials) also reflects a move away from the big banks.

All of this highlights the problem with investing in ETFs that do not track an index. Granted, XTR’s asset mix is not subject to the whims of a fund manager and her worthless forecasts: it’s based on a series of quantitative screens “designed to identify and optimally diversify portfolio exposure” within prescribed limits. But this is still tactical asset allocation, a strategy commonly employed by active managers, and one that is of dubious value to investors.

XTR isn’t the only fund that makes tactical shifts according to market conditions: the iShares Core Portfolio Builders and Claymore CorePortfolios also do so. While these “ETFs of ETFs” offer one-stop diversification at low cost, investors need to check in once per quarter to make sure they are still comfortable with the risk levels. Or, better yet, consider building your own ETF portfolio using a long-term asset allocation that doesn’t rely on guesswork.

This post is part of a series called Under the Hood, where l take a detailed look at specific Canadian ETFs or index funds.

The fund: iShares S&P/TSX Completion Index Fund (XMD)

The index: This ETF tracks the S&P/TSX Completion Index of midcap and small-cap Canadian stocks. It includes all of the stocks in the S&P/TSX Composite Index except for those in the large-cap S&P/TSX 60.

The cost: The fund’s MER is 0.59%.

The details: There are currently 251 stocks in the iShares S&P/TSX Composite (XIC), which is a core holding in my most popular model portfolios. About 73% of XIC (by market capitalization) is concentrated in the largest 60 companies, which can be bought separately with the iShares S&P/TSX 60 (XIU). XMD holds the other 27% of the market, comprising 191 companies. Justin Bender has written a good overview of how these two funds complement each other.

Canada’s large-cap market is absolutely dominated by a small number of companies—mostly banks and energy giants. Just 10 companies make up a third of this country’s market (and half of the S&P/TSX 60). XMD is also highly concentrated in these three sectors, but it still offers somewhat better diversification. The fund is about 30% energy, but this is spread across 50 small companies, and only severn of them comprise more than 1% of the fund. XMD is still about 24% financials, but many of these holdings are REITs and small investment firms, with almost zero exposure to banks. Another 21% is in materials, with a number of small gold and silver miners making up most of that share.

XMD is not representative of the Canadian market on its own, so it’s not suitable as a core holding. However, investors who want to tilt their portfolios toward smaller stocks can do so by holding equal amounts of XIU and XMD. This strategy would have outperformed the broad market (represented by XIC) by 57 basis points a year over the last decade:

The alternatives: There are no other ETFs or index mutual funds tracking this index.

Bottom line: XMD is an extremely useful fund that probably should be more widely used by investors, especially those with large portfolios who are willing to divide their Canadian equity holdings among two funds. It should be combined with a large-cap fund such as XIU, the Horizons S&P/TSX 60 (HXT), or the Claymore Canadian Fundamental (CRQ). (This latter pairing is what you’ll find in my Über-Tuber portfolio.)

The fund has become even more interesting since the appearance of commission-free ETFs at three online brokerages. Not only do Scotia iTrade, Qtrade and Virtual Brokers all include XMD among their lists of eligible ETFs, they also offer the  HXT without commissions. A combination of 75% HXT and 25% XMD would have a weighted annual fee of just 0.21%, which is even cheaper than XIC. Holding equal amounts of each would cost 0.33%.

Disclosure: I currently hold XMD in my personal account.

On Monday, I wrote a post about a new Canadian dividend fund from XTF Capital. That fund is one of five new products from the newest ETF provider in the country, all of which are based on indexes provided by Morningstar Canada. Two more began trading on Wednesday: the XTF Morningstar Canada Value Index ETF (FXM) and the XTF Morningstar Canada Momentum Index ETF (WXM).

In my original post, I criticized XTF Capital and Morningstar for not making the Index methodologies public. It turns out that wasn’t quite fair:  XTF president Barry Gordon contacted me and explained that the index construction rules are indeed fully transparent, and although they were not on the XTF website at the time, they are now.

I ended up speaking with Mr. Gordon about his company’s partnership with Morningstar, and it’s an interesting story. Although XTF Capital is a small firm compared with its competitors, it has partnered with one of the most well-known research firms in the investment industry, and the result is some unique and interesting ETFs. They are all passively managed, but they use rules-based strategies designed to deliver better risk-adjusted returns than the overall market.

A new family of strategy indexes

XTF Capital approached Morningstar and asked them to create indexes based on their Computerized Portfolio Management Services. CPMS is a service that Morningstar sells to advisors and portfolio managers who are interested in executing particular investment strategies—such as those based on dividends, value factors, or momentum. Rather than doing their own security analysis, subscribers pay Morningstar a fee for comprehensive research and recommendations.

The long-term performance of the CPMS strategies are impressive—albeit hypothetical. Their Earnings Value strategy, which is the basis for the new value ETF, returned 19.35% over the last 10 years, compared with 7.54% for the S&P/TSX Composite. The CPMS Momentum strategy claims an annualized return of more than 20% since 1985.

Gordon readily admits that investors should not expect returns like that: rules-based strategies don’t always live up to their promise in the real world, where they face the headwinds of management fees, transaction costs, market impacts and human behaviour. Indeed, the CPMS data do not include investing costs or tracking error of any kind, and they assume that all recommendations are implemented instantly. The ETFs will have management fees of 0.60%—not including HST—and will incur trading costs and other expenses that will lower their returns compared with the CPMS numbers.

Moreover, Morningstar had to make sure that its new indexes were truly investable, which meant eliminating small, illiquid stocks and rebalancing quarterly rather than in real time. Gordon says the company will not announce the exact rebalancing dates to discourage front-running.

As for human behaviour, that’s one area where the new indexes might prove to be superior to your average portfolio manager. Gordon says he knows many people in the industry who subscribe to CPMS, “but I rarely find anyone who does exactly what the methodology tells them.” Like most human beings, fund managers tend to ignore data or recommendations that go against their intuition—and usually they’re wrong. “So it will be interesting to see what happens in the index context, where there will be no discretion,” Gordon says. “We can’t override it and say, ‘No, that’s too heavy a weighting to X.’ The index will generate whatever it generates, and we will replicate that.”

That’s music to the ears of a passive investor.

Last June, a new ETF provider appeared in Canada with little fanfare. I didn’t write anything about the launch of XTF Capital at the time, because their first lineup of products was a series of covered call ETFs and a convertible bond ETF that have little or no relevance to Couch Potato investors. However, last week XTF launched the first three ETFs in a new family that will track indexes provided by Morningstar. One of these, the XTF Morningstar Canada Dividend Target 30 (DXM), may be of interest to passive investors who use a dividend-focused strategy. So it’s worth a closer look.

Of course, the Canadian dividend ETF space is already a little crowded, with the iShares Dow Jones Canada Select Dividend (XDV) and Claymore S&P/TSX Canadian Dividend ETF (CDZ) currently holding almost $1.7 billion between them. Broken down by sector, this new XTF fund is about 25% financials (that’s half as much as XDV, but about 4% more than CDZ) and almost 30% energy, which is a far greater share than either of its competitors. It also holds 13% in utilities and almost 20% in telecoms.

The ETF’s fact sheet also breaks down the fund’s exposure to size and value factors using the Morningstar style boxes, which is an interesting feature. These style boxes tell you what percentage of the fund’s assets is in large, mid, and small cap stocks, and what percentage is in value, blend and growth stocks:

Of the 30 stocks in the new ETF, only five are also in both XDV and CDZ (Scotiabank, Fortis, IGM Financial, Shaw Communications and Telus), which is a bit surprising. Another 15 are in one or the other competitor, leaving 10 stocks that appear only in DXM.

What’s in the box?

Barry Gordon, president of XTF’s parent company, First Asset, was quoted in The Globe and Mail as saying that with these Morningstar indexes, “we are striving to deliver better returns with less risk than the broader market.” The ETF’s fact sheet includes hypothetical returns for the Morningstar Canada Dividend Target 30 Index, which would have outperformed the S&P/TSX Composite dramatically over the last three, five and 10 years, with a lower standard deviation to boot.

That’s quite a claim, but backtested returns of new indexes are almost worthless—it is always possible to identify a strategy that would have worked in the past, but this offers no guarantee that it will work going forward. The claim is especially dubious when it’s unclear exactly what strategy is being employed. That’s my biggest concern with this new ETF. The individual holdings are transparent, but the methodology is anything but: we’re told only that the Morningstar index is “based upon proprietary research” and that “it reflects the performance of 30 dividend-paying, Canada-based equities, screened for, among other things, above-average returns on equity and high cash flows relative to debt.” It seems to weight all of its holdings equally, rather than by market cap or yield, though even that is not made explicit.

While I fully understand the business reasons for creating products that keep their strategy under wraps, I’m not attracted to them as an investor. Black-box ETFs like this one suggest that there are magic formulas that can beat the market, and that investors should be paying for access to an exclusive club. But one of the pillars of passive investing is that returns come from exposure to known risk factors, not from secret sauce. This ETF provides a reasonably well diversified basket of Canadian dividend stocks and may be just fine for investors who want that in their portfolios. But whether it will provide superior risk-adjusted returns in the real world is an open question.

[Update: After this post went live, XTF Capital supplied a copy of the index methodology. See the comments section for an explanation and a link.]

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.