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.