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One of my recent Investor Clinic videos on dividend ETFs prompted this query from a reader:
"I'm wondering about your thoughts on an international dividend ETF such as the Claymore Global Monthly Advantaged Dividend ETF. I like the idea but the ETF forward agreement structure seems complicated and scares me off a little." - Jeff in Ottawa.
Well, Jeff, ask and ye shall receive, for today we'll take an in-depth look at that very ETF. You're right, it's a bit complex, so I've asked Claymore chief executive officer Som Seif to help us navigate the structure. I've also run some of the details by a derivatives expert to get his opinion. So let's dig right in, shall we?
THE BASICS
The Claymore Global Monthly Advantaged Dividend ETF is an exchange-traded fund designed to track the Zacks Global Multi-Asset Income Index. The index comprises about 250 companies, including dividend-paying stocks, real estate investment trusts, master limited partnerships, preferred shares and income trusts.
The weighting is about 40 per cent U.S. companies and 60 per cent international, including 9 per cent from Canada. Zacks uses a proprietary methodology to choose companies with "potentially high income and superior risk-return profiles."
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You'll find plenty of well-known names here - Kraft Foods, Johnson & Johnson, Adidas - and some not-so-familiar ones - Portugal Telecom, Yanzhou Coal Mining.
The ETF hedges its exposure to U.S. dollars to minimize the impact of currency fluctuations for Canadian investors.
WHAT IS THIS FORWARD AGREEMENT THING ANYWAY?
For tax reasons, Claymore uses a derivatives contract with National Bank of Canada to convert, or "recharacterize," the largely foreign income generated by the portfolio into more desirable return of capital (ROC) and capital gains.
Because foreign dividends don't qualify for the dividend tax credit, the idea here is to make the foreign income more attractive, specifically for non-registered accounts.
Return of capital is generally non-taxable; instead, it is subtracted from the investor's adjusted cost base, ultimately giving rise to a larger capital gain when the units are sold. Capital gains are taxed at half the rate of income.
In 2008, the ETF's first year, distributions were 100 per cent ROC. The proportion of ROC is expected to gradually fall, and the amount of capital gains will slowly rise, over the five-year life of the forward agreement. But ROC should always account for a majority of the distributions, Mr. Seif said.
MY HEAD ISN'T SPINNING ENOUGH YET, MORE DETAILS PLEASE
The mechanics of the forward agreement are complex but they boil down to this: Claymore uses money invested in the ETF to buy a separate portfolio of non-dividend paying Canadian stocks. It then "swaps" the returns of these equities for the returns of the global dividend portfolio, which is in fact held by National Bank.
So the investor is actually getting a return of capital or capital gain from the non-dividend portfolio held by the ETF, but in an amount that equals the income from the global dividend portfolio held by National Bank. That's what allows for the favourable tax treatment of the distributions.
WHAT ARE THE RISKS?
"This is really not a new structure. It's been around for decades," Mr. Seif said. "It's very commonplace and a lot of mutual funds use [the forward agreement structure]."
The derivatives expert I spoke to, who asked to remain anonymous, agreed that the structure is sound. So long as National Bank is solvent and honours its end of the bargain - and there is no reason to expect it won't - the forward agreement needn't scare off investors.
