Before being bought by BlackRock early in 2012, Claymore Investments pioneered many new services and unconventional products. One of these was its so-called Advantaged ETFs, which used a complicated structure to convert fully taxable bond interest and foreign income into tax-favoured return of capital and capital gains.
Barely a year after these funds joined the iShares family, the 2013 federal budget took aim at this sleight of hand. While the government is grandfathering contracts already in force, it won’t allow new ones, which means the eventual end of the tax break promised by the Advantaged ETFs. A couple of weeks after the budget, iShares stopped accepting new subscriptions for these funds until they decided how to handle the situation.
The ETFs are open for business again, but several have new names and all have new strategies. Here’s a summary:
The iShares Global Monthly Advantaged Dividend has become the Global Monthly Dividend Index ETF (CYH). The tax-favoured structure is gone, but the investment strategy is largely the same: the fund is about half US and half international dividend stocks. However, the older version used two US-listed Guggenheim ETFs as its underlying holdings. Today the fund tracks a different index—the Dow Jones Global Select Dividend Composite—and holds its 300-odd stocks directly.
The iShares Advantaged Canadian Bond is now the High Quality Canadian Bond Index ETF (CAB). It’s a plain-vanilla bond fund tracking the same index as before, with a fixed target of 60% government and 40% corporate bonds, all investment grade. That compares with about 70% government bonds in the iShares DEX Universe Bond (XBB) and about 80% in the Vanguard Canadian Aggregate Bond (VAB). The average maturity (8.5 years) and duration (6.1 years) of CAB are both slightly lower than those of XBB and VAB.
The iShares Advantaged Convertible Bond has changed its name to the Convertible Bond Index ETF (CVD) and now holds its securities directly, which eliminates its former tax advantage. The underlying index remains unchanged.
A hybrid approach
While the above three funds no longer have any tax advantages, the iShares Advantaged High Yield Bond (CHB) and iShares Advantaged Short Duration High Income (CSD) have both retained their names and—at least temporarily, it seems—some of tax benefits. Both now use what BlackRock calls a “hybrid strategy,” whereby the current portfolio is covered by grandfathered contracts, but new inflows will be invested directly in the underlying bonds. According to BlackRock:
The Hybrid Strategy is intended to allow for the preservation of any tax benefits associated with the forward agreement until its expiration or earlier termination, while also allowing the fund to realize the benefits of accepting new subscriptions while respecting the growth limits for forward agreements set out in certain proposed new tax rules. BlackRock expects that these tax benefits will diminish over time as the fund accepts new subscriptions and the tax benefit is spread over the fund’s larger asset base.
What does it mean for investors?
ETF providers are loath to close funds because it would mean giving up hundreds of millions in assets under management. They’re relying on investors to fall prey to inertia and simply go on holding these ETFs long after they have outlived their usefulness. But if you own any of the former Advantaged funds you need to consider whether they still make sense.
Remember, unless you bought the ETFs for the wrong reason in the first place, you’ll be holding them in non-registered accounts. And once the forward agreements no longer apply, most these asset classes (especially high-yield bonds) don’t belong in taxable accounts. Like any other ETF filled with premium bonds, a fund like CAB belongs in a tax-sheltered account—assuming it has any place in your portfolio at all when comparable bond ETFs are cheaper. If you need to hold fixed income in a taxable account, consider a GIC ladder.
The only ETF that might retain some usefulness in a taxable account is CYH. Although its dividends are now fully taxable, that’s true of any foreign equity ETF, and because the fund now holds its stocks directly, rather than via an underlying US-listed ETF. That means there is an opportunity to recover international withholding taxes in a non-registered account. (For the details, see our recent white paper on this subject: CYH would offer similar advantages to what we’ve called Type F funds.) However this has to be balanced against its high MER of 0.68%.
My understanding from information posted here: https://canadiancouchpotato.com/2013/04/02/how-the-2013-budget-will-affect-etfs/
is that the CAB contract ends Nov 14, 2014, and thus it would retain its “tax-advantage” until that date. I had marked my calendar to look at BXF or ZDB as replacements close to that date. The way I read this post however, is that the CAB tax-advantage is already up!
@sleepydoc: It seems iShares decided to implement the changes before the forward contract expired rather than taking it down to the wire. They issued a press release to this effect on November 26:
http://ca.ishares.com/content/stream.jsp?url=/content/en_ca/repository/resource/press_release/pr_2013_11_26_en.pdf&mimeType=application/pdf
With these news, one may wonder how long other tax advantaged ETFs like Horizon’s HXT and HXS will last before the government shut them down…
Having never experienced an ETF closure, what are the implications when it does close? Does the discount brokerage force sell investors’ existing holding?
@Jas: That is always a possibility. Though I think the swap structure is safer than the forward agreement structure. Swaps have been around for a long time: in fact, a great many ETFs in Europe use this structure. If the government wanted to shut them down they likely would have done so by now.
@DL: Great question. When an ETF decides to terminate, it sends out a notice to unitholders and gives them several weeks warning. The unitholders then have the opportunity to sell the shares at any time before the termination date. If they do not do so then the holding gets automatically liquidated at its current net asset value and investor receives the cash. Here’s an example of a press release from a closure that occurred in the fall:
http://www.newswire.ca/en/story/1252753/horizons-etfs-announces-closure-of-certain-etfs
I bought CYH for a taxable account in 2012. I plan on keeping it and in fact I like the simplicity of the conventional structure and I prefer the new index it tracks. I was never a fan of the Guggenheim index. I also prefer the that it holds the stocks directly.
I am not a fan of the high MER but I am not sure there is a comparable $CAD ETF. If there is I would be curious to know.
At the beginning of the year I created a portfolio on Google finance with several index efts including TD e-series funds and similar US dollar vanguard index funds. So far the TD funds look to be outpacing vanguard by 3-5 percent. Is this simply a result of currency fluctuation as the Can dollar has dropped, or is it something else?
@Cus: Hard to say anything without knowing the specific funds you’re comparing. But in general Google Finance is a poor tool for looking at fund performance, because it measure price only and ignores dividends and interest. always look at total returns, which are available on each fund’s website.
Total newbie here, two questions:
1) If I hold a broad equity index fund, there will presumably be some stuff with capital gains and some that pay dividends. Seeing that they are taxed differently, how do I decide what account is best?
2) Are corporate bonds and government bonds taxed the same?
@Jay: In most cases, asset location (which account should hold each asset class) is only a concern when your registered accounts are maxed out and you need to hold some assets in taxable accounts. If you’re not in that situation, then you should determine whether an RRSP or TFSA makes more sense for you and invest everything there.
Yes, interest from corporate and government bonds is taxed the same.
A little off topic…
Would the the new RBC Quant US Dividend ETF be an appropriate substitute to say VUN for the US component of my portfolio? The dividend yield seems to be fairly attractive – 3.95%. And is there any reason to think that number wouldn’t be accurate because of how new it is?
Do fund companies facilitate a swap from one etf to another eg CAB to XSB? If so how is that done?
@Al: There is no way to “swap” one ETF for another. You would simply have to sell one and buy the other in the usual way.
Dan et al – Another query a bit off topic for CP’ers… but given its tax time again. I hold a Global CP portfolio with Scotia (partly in TFSA, mostly not), and did some rebalancing (selling and buying) in 2013. And… I am relatively new to all of this.
What I find incredibly confusing and frustrating each year is what the heck do I need to provide to Revenue Canada at tax time regarding my CP investments without mistakenly getting into hot water. Every year I seem to get a notice back indicating I have done something wrong. Yes, I get T5, interest income, etc, that shows up in the mail. But how do you account for losses, dividend income, etc etc. I use Scotia and while the online website has improved ion provding one’s data, on tax matters with investments its all relatively cryptic to a rookie investor.
I have never found a really clear outline (for Dummies, or even in Dan’s new CP book) for CP portfolio income tax accountabilty for the DIYer. At this point I feel like just shoving it all over to a tax service and sucking up the cost, but that flies in the face of the CP aim of saving money. Surely this need not be THAT difficult?
I realize there are probably a million unique scenarios and maybe difficult to generalize, but some tips on the basics of CP and the tax accountability, and pointing out the “gottchas”, would be really useful.
@Lenny: Dividend income (both Canadian and foreign), interest and distributed capital gains are all reported on your T-slips. When you sell an investment in a taxable account, you are responsible for calculating the adjusted cost base and determining the capital gain. Your brokerage may report ACBs accurately, but not always. I have written about this here, with specific instructions for ETFs.
https://canadiancouchpotato.com/2013/04/04/calculating-your-adjusted-cost-base-with-etfs/
As you can see, this is not particularly easy for the average investor. People with significant investments in taxable accounts really should consider using an accountant or other preparation service. The Couch Potato strategy strives for low cost, but that does mean DIY accounting, especially if you already have a history of CRA noticing errors on your return.
Lenny – Can you provide some examples of the issues that the cra discovers in your tax returns?
@Lenny: Good tax software will help with computing ACBs and reporting gains and losses, but unfortunately you do have to keep detailed records if you’re trading in taxable accounts. (You actually have to keep records going as far back as the oldest security you’ve held, which in some cases for some people may be decades.)
If you think this is onerous, try trading options. The tax reporting burden for anything nontrivial becomes almost not worth it.
Hi CCP and other contributors,
I always wondered how could a future retiree transform his growth oriented portfolio into an income oriented one without triggering 20 years or more of capital gains. Let’s say you started investing at 25 and now you are 60 yrs old and your unregistered account holds both broad US and Canadian ETFs like ZCN and VUN for example. Is there a good tax strategy to sell them into diversified dividend funds?
Too bad I’ll bee working during your webinar, I’d have loved to be a part of it.
Thanks
@Serge: That’s a huge question that I have been wanting to tackle in a white paper at some point. The short answer is that there is no need to “transform” the portfolio in retirement. Drawing down the portfolio to meet monthly expenses does not mean adopting a dividend-oriented strategy. The last section of this article I did for MoneySense introduces this idea:
http://www.moneysense.ca/invest/the-income-illusion
Dan, I hold your previous ‘yeild’ hungry portfolio entirely in a taxable account as the registered is maxed.
With these changes I know I’m getting hooped now, as far as taxes go. Without giving up on this strategy ( which I understand you take issue with ) is there any immediate changes for a quick win?
Thx
@JR: I would start by looking at the overall asset location and keeping as much of the fixed income as possible in the registered accounts. If you must hold fixed income in a taxable account, GICs are a much better choice than bond ETFs. And for equities, I would simply consider the traditional index funds I recommend in the current model portfolios. Or you can substitute dividend ETFs if you prefer: just keep in mind that using high-dividend foreign ETFs in a non-registered account is likely to be less tax-efficient.
Is a recording of the webinar available for those who could not view it live?
@Jan: The webinar was cut short by technical difficulties today, so we are rescheduling it for Wednesday, March 19, and noon ET (9 am Pacific). And yes, a few days after it runs it will be available as a recording to view at your convenience. Thanks for your interest.
@Cus: This is a cold-call for assistance in the hope that your expertise with Google Finance can help me out.
I have am trying to construct a Google spreadsheet which flags asset value discrepancies that need rebalancing. I have figured out using Google Finance commands to populate fields with share prices. This works for most of my holdings. However, 2 Canadian stocks, FXM and XEC, have the same tickers as US listed stocks, so if I use these same ticker labels I get the info for the US stocks, not the info I want. I have tried using FXM.TO and XEC.TO but this gives me an error message. Do you (or anyone else out there) have a fix for this problem?
Hello Dan,
Do you have the link for the recording? I was looking on the Credential site but could not find it.
Thanks
Mike
@Mike PQ: They need a little time to edit the recording, so stay tuned. Should be posted shortly.
Hi,
Question for CCP on convertible bond funds,
In January RBC started a new corporate class convertible bond fund. All other other RBC corporate class bond funds were closed in 2013.
How would a convertible bond fund fit into the couch potato portfolio?
Thanks,
K
@Ken: My first reaction is to say that convertible bonds don’t fit into a Couch Potato portfolio, period. It’s not an asset class that lends itself to passive, diversified, low-cost funds.
Thanks CCP,
Unfortunately it is now the only fixed income option under the RBC Corporate class.
Can convertibles substitute for regular bonds as an asset class?
Thanks,
Ken
ps. I’m looking at corporate class because it’s a leveraged investment. RBC has the lower fee D Series.
@Ken: I don’t mean to be unhelpful, but the strategy you’re describing (leveraged investing with actively managed mutual funds) is completely different from the one I advocate, so I don’t think I’m the right person to ask.
Hi CCP,
No problem, I understand
I just wanted to get an opinion on convertible bonds vs. regular bonds as an asset class. i.e. correlation and volatility.
Regards,
Ken
Hi CCP and others: I’m a Cdn retiree and relative newbie to the ETF field. Here’s my question. As the Cdn tax advantages for investing in ETFs are slim, and ETFs based on Cdn stock exchanges have high MERs, are the after-tax returns worth it, when investing in more competitive ETFs based elsewhere? I’m referring principally to those ETFs trading on US-based exchanges, and filling out a W-BEN form to cancel US tax bites and triggering instead the Cdn tax application?
@Gettin’ Older: Thanks for the comment. I’ll start by challenging your two assumptions: that “Cdn tax advantages for investing in ETFs are slim, and ETFs based on Cdn stock exchanges have high MERs.” In taxable accounts US-listed ETFs may offer no tax benefit, although in RRSPs they often do. So it depends on what type of account you’re using to hold the fund:
https://canadiancouchpotato.com/2013/12/09/ask-the-spud-when-should-i-use-us-listed-etfs/
The differences in MER are also getting smaller every day: we’re often talking about 10 bps or less now, which means you really have to be able to convert your CAD to USD at a very low cost to make US-listed ETFs worthwhile.
Forgive my ignorance but I own Advantaged Canadian High Yield Bond Fund (AHY.UN) http://www.scotiamanagedcompanies.com/smc/profile.do?company=AHY
Is this in a similar situation or a completely different beast?
@Sean: “It is expected that the quarterly distributions received by unitholders will be characterized primarily as returns of capital and capital gains for tax purposes.” Sounds like the same structure to me. This structure won’t be allowed to continue after the current agreement expresses. Would be worth checking with Scotia directly.