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.

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According to the Canadian ETF Association, iShares is already the dominant player in the ETF sector with a market share of 67%. Claymore currently occupies the #2 slot with a market share of 15.5%. When the deal is consummated (unfortunately, it is likely a question of “when”, not “if” the deal will be approved, because BlackRock can probably successfully argue that its market share of the overall fund business is fairly small), BlackRock’s market share will become even more dominant at 82.5%. Or look at it this way: iShares currently has 13 out of the 20 largest ETFs by assets under management. After acquiring Claymore, BlackRock will have 18 out of the top 20 ETFs.

It is true that other ETF vendors are competing strongly. In 2011, BMO was virtually tied with iShares in net ETF creations at 33%. Claymore occupied the #3 spot with 20%. Combining iShares with Claymore (Jon Chevreau cleverly dubbed the combination “ClayShares”) would mean BlackRock would have more than 50% of the 2011 ETF sales to go along with its dominant position in the ETF landscape. It is hard to see how the creation of a virtual monopoly will deliver innovation and choice for ETF investors.

Related Reading:

• State of the Canadian ETF Industry Q3-2011
• iShares ETFs becoming more expensive
• Wrap ETFs from Claymore
• More New ETFs
• Scotia iTrade’s Commission-Free ETFs: A good deal for some investors

iShares + Claymore is not good for Clients is brought to you by Canadian Capitalist — Helping you to invest & prosper.

If you’re investing outside of tax-sheltered accounts like RRSPs and TFSAs, you need to choose your investments carefully—otherwise you risk giving a big slice of your returns to the good people at the Canada Revenue Agency. Today we’ll look at ways to create a tax-efficient index portfolio using some innovative ETFs.

Swapping dividends for capital gains

In Monday’s post, I explained that Canadian dividends are not always as tax-advantaged as people believe. Capital gains are not only taxed at a lower rate in the highest tax brackets, but investors can also control when to take them—dividends, on the other hand, are taxable in the year they’re paid, even if you reinvest them.

Horizons’ swap-based ETFs—which I wrote about here—were designed to address this issue. They use a type of derivative that allows investors to earn the same return as the index, without collecting any distributions. Dividends paid by the companies in the index are reflected in the fund’s return, but all of the growth is characterized as capital gains and deferred until the fund is sold. There are currently just two funds in the family: the Horizons S&P/TSX 60 (HXT) for Canadian large-cap stocks, and the Horizons S&P 500 (HXS) for US large-caps.

The tax advantage is especially large for HXS, because dividends from US companies are fully taxable, while capital gains are taxed at half that rate. Consider this: if you held the iShares S&P 500 Index Fund (XSP) in 2011, you received $0.24 per share in cash dividends, a yield of about 1.6%. At the highest tax bracket, you would have lost almost half of that to taxes, reducing your return by about 80 basis points. If you held HXS instead, you would have received a similar 1.6% price appreciation instead, and you would have paid no tax. If you eventually sell the fund at a profit, you’ll pay tax on only half the gain.

Forward thinking

Claymore’s Advantaged ETFs—read a detailed description here—use forward contracts that “recharacterize” bond interest or foreign dividends as capital gains or return of capital (ROC). Unlike swap-based ETFs, which pay no distributions, the Advantaged ETFs are design for investors who want current income.

Return of capital is the most tax-efficient of all distributions, though it’s not a free lunch. ROC is not taxed in the year it’s received: instead, it lowers your adjusted cost base, and if you sell your shares at a profit in the future, you’ll incur a capital gain. So you’re not getting truly tax-free income—you’re really just getting your own money back—but you are generating tax-deferred cash flow. This document from Claymore explains the idea.

You can see why ROC is preferable to bond interest, which is fully taxable. In 2011, the Claymore Advantaged Canadian Bond (CAB) returned 6.8%. Roughly half of that came from price appreciation, while the other half came from distributions. However, unlike every other bond ETF, those distributions were return of capital, not interest. So you would have collected that entire 6.8% return without a tax bill.

Before you get too excited, there are downsides. All of the 2011 distributions from Claymore’s Advantaged ETFs were return of capital, but that won’t always be the case. In 2010, for example, CAB’s distributions were all capital gains. These would have been taxable—albeit at only half the rate of bond interest.

More important, the Advantaged ETFs have considerably higher costs than plain-vanilla index funds, which will lower their pre-tax returns. Those added costs offset some of the tax savings, and may even wipe out the advantage altogether. For example, both the iShares DEX Universe Bond (XBB) and BMO Aggregate Bond (ZAG) returned well over 9% last year—dramatically outperforming CAB. Even if you lost half your interest income to taxes, you might still have been better off with XBB or ZAG.

If you’re out of RRSP and TFSA room, you could use these ETFs to build a reasonably well diversified and tax-efficient portfolio of Canadian stocks (HXT), US stocks (HXS) and bonds (CAB). In some years—including 2011—you’ll have no tax payable at all. Just spend some time researching these complex products first, and don’t invest in anything you don’t understand simply because you think you’ll save some tax.

H&R Block software giveaway

Speaking of tax, the folks at H&R Block have offered to give away copies of their DIY tax software to five lucky Canadian Couch Potato readers. To enter the draw, leave a comment below or tweet this post to your followers before midnight EST on Sunday, January 29. I’ll announce the winner next Monday.

Thanks to the new Horizons U.S. Dollar Currency ETF, Norbert’s gambit is now easier than ever. This ETF is available in two versions. The first, with the ticker symbol DLR, is bought and sold in Canadian dollars, while the second, DLR.U, trades in U.S. dollars. The difference in price between the two versions reflects the current exchange rate: at press time, DLR was trading at $10.18 Canadian, while DLR.U was priced at $9.96 U.S.

Here’s how you can use this ETF to exchange $10,000 Canadian:

1. Get a quote for DLR and calculate how many shares you can buy for $10,000 Canadian.
2. Place an order for that number of shares. The trade will settle in Canadian dollars.
3. Call your discount brokerage’s customer service desk and ask them to take your DLR shares and “journal them over” to the U.S. dollar side of your account, where they should show up as DLR.U.
4. Place an order to sell all of your DLR.U shares. The trade will settle in U.S. dollars.

You’ll pay two commissions and lose a little on the bid-ask spread, but you’ll still save big overall. Note that this technique only works if you can hold U.S. dollars in your account. Most brokerages don’t allow this with RRSPs.

On the day his company announced it was acquiring Claymore, BlackRock’s CEO Bill Chinery called ETFs “electric cars in a world of internal combustion engines.”

What he meant was that ETFs, despite the attention poured on them by the media and DIY investors, are still only a small part of the fund industry. ETFs in Canada now manage about $43.1 billion in assets. By comparison, Canadians have $778.5 billion invested in mutual funds—about 18 times more.

That’s a big gap, but it’s been closing for a few years now. According to a recent report, ETFs in this country saw more than $7.6 billion in new sales in 2011, increasing their total assets by nearly 13%. Compare that with another report from the Investment Funds Institute of Canada. Canadian mutual funds, it says, now manage $8.8 billion less than they did at the beginning of 2011. Of course, part of that decline is a result of negative equity returns and not investor withdrawals. But the stats do make it clear that the mutual fund industry is moving in the opposite direction of ETFs:

• Balanced mutual funds saw inflows of $27.7 billion in 2011—a hefty sum, but almost $1 billion less than the previous year.

• Bond mutual funds accepted $8.87 billion in new money last year, compared with $11.1 billion in 2010, about a 20% decrease.

• Equity mutual funds saw net redemptions of $10.8 billion during 2011.

ETFs may still be electric cars, but the mutual fund industry is looking more and more like a tractor trailer with a hole in the fuel tank.

Every silver lining has a black cloud

Not everyone agrees that ETF growth is encouraging. “To me, the ETF sales numbers are both underwhelming and disappointing,” wrote Tom Bradley of Steadyhand Investments this week. “In the context of a wealth management industry with over $1 trillion in client assets, $7 billion doesn’t represent much of a market share swing.”

I also share Bradley’s other concern: “I have to wonder what portion is being used by individual investors to implement low-cost, long-term strategies.” Indeed, while it’s tempting to see the growth of ETFs as a triumph for Canadian index investors—who are finally waking up to the fact that they’ve been paying too much, for too little, for too long—the numbers don’t support that:

• About $900 million of the new money that went into ETFs in 2011 (12% of the total) went into the iShares S&P/TSX 60 (XIU), which is mostly a tool for institutional investors. It’s unlikely that much of that $900 million came from newly sprouted Couch Potatoes.

• Another 16% of ETF inflows ($1.2 billion) went into covered call ETFs. While these ETFs may have a role in some portfolios, such widespread enthusiasm for covered calls probably has more to do with chasing yield than prudent investing. The enticing distributions paid by these ETFs (often 7% to 9%) are not likely to be sustainable.

• As Bradley points out, there’s “some serious performance chasing going on.” Fixed-income ETF assets were up 44% in 2011, a year that saw excellent bond returns. But other than XIU, equity ETFs saw very little new money—just $400 million, or barely 5% of the total inflows. In a year where emerging markets performed poorly, investors pulled $45 million out of the Claymore BRIC ETF.

I’m encouraged that Canadian investors are putting pressure on the mutual fund industry, and pleased to see that more are embracing ETFs. But part of me thinks they’re doing the right thing for the wrong reasons.

Announcements in the ETF world are mostly tedious these days—usually they involve the launch of another exotic and increasingly narrow new product. That’s why yesterday’s announcement that BlackRock is buying Claymore Investments was a shocker. I’m not the only one who didn’t see that coming.

BlackRock, of course, is the parent company of iShares, the largest ETF provider in Canada, with about $29 billion in assets—about 75% of the market. Claymore’s family of ETFs and closed-end funds currently have about $7 billion under management. Together, the two families will be a powerhouse in the ETF space in this country.

It’s way too early to tell what this will mean for Canadian investors, but overall I expect it will be a positive development. I’ve always liked Claymore’s entrepreneurial spirit and its desire to innovate. For example, the company was the first to create preauthorized contribution plans that allow investors to add money to their holdings each month without incurring trading commissions. Their recent partnership with Scotia iTrade—which makes all Claymore ETFs available with no brokerage commissions—was also a game changer that prompted Qtrade to follow suit. (Claymore’s DRIP program, in my opinion, was not as innovative or as significant as often believed.)

But as refreshing a presence as Claymore has been, I think BlackRock will take them to the next level. The iShares products are probably the most prudently managed ETFs in the country, with consistently low tracking errors, even when the funds are small. I’ve also found them to be among the most transparent and straightforward firms to deal with as a journalist. The Claymore ETFs are now in good hands.

Opposites attract

In some ways, the two ETF families are unlikely allies. iShares was among the pioneers in the industry more than a decade ago, and they’ve remained steadfast in their position that traditional indexing—plain vanilla, cap-weighted funds that track third-party benchmarks—is still the best solution for investors. Claymore, on the other hand, has been a vocal critic of cap-weighting and the leading Canadian proponent of RAFI fundamental indexes.

But the ETF industry is changing, and both companies recognize that. Investors already have access to plenty of low-cost traditional index ETFs, so there’s little room for growth in that area. The only way a new player could compete in the traditional ETF space would be to lower fees even more. That’s what Vangaurd has done with its Canadian launch, but they are the only company with the size and influence to pull that off. No one else is going to be able to compete on price.

BMO is competing with superior distribution: they have an army of advisors (most of whom have little or no interest in passive portfolio strategies, by the way) selling their products—and they’re doing that extremely well. RBC looks poised to do the same. Meanwhile, other ETF providers will have to compete with each other by offering more and different product choices.

With that in mind, Claymore and iShares are actually a perfect fit. Although they have 82 ETFs between them, there is almost no overlap. I can’t think of a single ETF that is an obvious candidate to be closed or merged with another as a result of this merger. While many asset classes are covered by both Claymore and iShares products, the funds usually track use very different indexes and strategies.

Index investors will be watching with interest as this one unfolds over the next few months.

I’ve looked at the tracking error of S&P 500 currency-neutral funds in past years but the tracking errors in the iShares CDN MSCI EAFE 100% Hedged to CAD Dollars Index (TSX: XIN) remained a mystery because I didn’t have the annual return data for the MSCI EAFE Index* in local currency. XIN holds the iShares MSCI EAFE Index fund (NYSE Arca: EFA) and hedges the foreign currency exposure that EFA’s holdings are denominated in, so that the returns of stocks will not be impacted by changes in the exchange rates between Canadian Dollars and Yen, Pound, Euros and other currencies. (As an aside note that even though EFA trades in the US, Canadian investors holding EFA are not affected by fluctuations in the exchange rate between the CAD and USD but are exposed to the fluctuations between the CAD and a basket of currencies such as Yen, Pound, Euros etc.).

Fortunately, MSCI Barra reports the returns of MSCI EAFE and other MSCI indices in local currencies on their website. Armed with that data, we can look at how well XIN tracks the MSCI EAFE in local currency terms. The following table shows the annual total returns of MSCI EAFE Index in its local currencies (column 2) with XIN (column 3). The results are consistent with our earlier analysis of the tracking error of XSP. XIN shows an annualized tracking error of 1.30%, which is lower than the tracking error shown by XSP but still wide enough to suggest that currency hedging is highly likely to be unprofitable.

 
When a Canadian investor holds a foreign investment directly, they take on the risk that currency fluctuations will affect their returns. Sometimes, the fluctuations will be in the investor’s favour. Other times, as Canadian investors directly holding US securities can readily attest to, fluctuations will hurt returns. Canadian investors in the iShares MSCI EAFE Index Fund (EFA) would have experienced a significant boost from the currency effect. In local currency terms, the MSCI EAFE Index lost 17.3% over the 2006 to 2011 period. Since investors in XIN trailed the index by an annualized 1.30%, XIN’s loss over the same six year period is 23.73%. However, a Canadian investor holding EFA directly would have a loss of 13.91% over the same time period.

The verdict on currency-hedging then (based on an admittedly short history of just 6 years) is clear: Long-term investors are highly unlikely to profit from hedging their currency exposure because currency effects have to overcome significantly large tracking errors simply to break even. When currency effects are negative (as it was the case of the CAD/USD and US markets over 2006 to 2011), currency-hedging still did not show a profit due to tracking error. With positive currency effects (as was the case with CAD/basket and EAFE index over 2006 to 2011), currency-hedged investors are trailing even more because investors did not get the currency boost and paid for their hedging efforts through tracking error.

* – MSCI EAFE Index tracks stock markets in Europe, Australasia and Far East and holds securities that trade in countries such as Japan, the UK and Germany.

Related Reading:

• The Costs of Currency Hedging
• A Tour of ETFs: iShares MSCI EAFE Index Fund
• Comparing Currency-Hedged and Unhedged Holdings
• Flavours of an Index Fund
• Performance of Currency-Neutral S&P 500 Index Funds

Performance of the Currency-Neutral MSCI EAFE Index Fund is brought to you by Canadian Capitalist — Helping you to invest & prosper.