Understanding Claymore’s Advantaged ETFs

In a series of posts earlier this month, I tried to demystify the swap-based ETFs launched by Horizons last year. These funds use a type of derivative called a total return swap to get exposure to the companies in the S&P/TSX 60 or the S&P 500 without actually holding any of the stocks in these indexes.

The primary benefit of using the swap structure is that the investor does not get an annual tax bill for the dividends. Instead, all the growth compounds until the investor sells her units of the ETF, at which point it is taxed as a capital gain.

While the Horizons ETFs are the only ones in Canada using total return swaps, Claymore also offers a family of ETFs that use a rather complicated structure designed to make them more tax-efficient:

Claymore Global Monthly Advantaged Dividend (CYH)
Claymore Advantaged Canadian Bond (CAB)
Claymore Advantaged High Yield Bond (CHB)
Claymore Advantaged Short Duration High Income (CSD)
Claymore Advantaged Convertible Bond (CVD)

One step forward

Like swap-based ETFs, these Claymore funds give you exposure to a market index without actually holding the assets in that index. But rather than using swaps, the Advantaged ETFs use forward agreements.

The best way to explain this arrangement is with an example. Let’s use the Claymore Advantaged Canadian Bond ETF (CAB). When an investor buys units of this fund, Claymore uses the cash to assemble a portfolio of non-dividend-paying Canadian stocks. (Yes, stocks, even though this is a bond ETF.) This portfolio of stocks is called the “top fund.”

Claymore than sells these stocks to a counterparty—in this case, TD Bank—with the settlement to occur at a future date. The counterparty, in turn, sells these stocks short and uses the proceeds to purchase the bonds in the index. This portfolio of bonds is called the “bottom fund.” According to the terms of the forward agreement, the counterparty must then settle the deal by delivering the return of the bottom fund, net of fees, to Claymore, who distributes these returns to the CAB’s investors.

If your head isn’t spinning, you may have figured out that the returns of the top fund (the Canadian stocks) are actually irrelevant to the ETF investor. This is because the counterparty has both long and short positions in the stocks, so it is perfectly hedged. Therefore, the only market exposure in the bottom fund—and therefore the only returns it delivers to the CAB investor—comes from the bond portfolio.

What’s the Advantage?

Why structure an ETF like this? The answer is that the forward agreement allows Claymore to characterize the ETF’s returns as capital gains, rather than as bond interest or (in the case of the Claymore Global Monthly Advantaged Dividend ETF) foreign dividends. They can do this because, technically, the ETF’s returns are coming from buying and selling the  Canadian stocks in the top fund.

The potential tax savings here are significant: both interest and foreign dividends are fully taxed as income, while capital gains are taxed at only half your marginal rate.

Unlike Horizons’ swap-based ETFs, the Claymore ETFs pay monthly distributions, which makes them suitable for income-oriented investors. While the distributions are primarily treated as capital gains, some may also be characterized as return of capital (ROC). Because ROC is not taxable immediately, investors may think of it as tax-free income, but it’s not. ROC lowers the adjusted cost base of the ETF units, which will lead to capital gains in the future. So it’s best to think of ROC simply as a deferred capital gain.

Later this week, I’ll look at the costs and risks involved in the Advantaged ETFs and help you decide whether they have a place in your portfolio.