New Currency Unhedged ETFs from iShares

April 16, 2013


ETF investors have long clamoured for Currency unhedged funds traded on the TSX for reasons outlined here, here and here. While it is true that Canadian investors can get direct access to foreign stocks through a long list of ETFs that trade in the US exchanges, these funds have one drawback that cannot be overcome — US-listed ETFs are considered in situ property and could be subject to US Estate Taxes. Granted, US Estate Taxes have become less problematic for most Canadian investors since the passing of last-minute legislation to avert the fiscal cliff. Essentially, Canadians with less than $5 million (US) in total assets will be able to avoid US Estate taxes entirely.

Still, Canadian-listed ETFs that do not hedge currency will be valuable for investors who do not want to look for cheaper methods of converting Canadian dollars into US dollars and who do not want to pay the usurious foreign exchange fees charged by most discount brokers. Last year, Vanguard Canada introduced the S&P 500 Index ETF (TSX: VFV, MER 0.18 percent), a fund that tracks the S&P 500 index. Now, iShares has launched three new ETFs that started trading on the TSX yesterday. They are:

iShares S&P 500 Index ETF (XUS): Track the S&P 500 index, a market-cap weighted index of 500 large US corporations. MER is 0.14 percent. Note that the ETF is essentially a wrapper around the iShares Core S&P 500 ETF (IVV) that trades on the NYSE Arca exchange.

iShares MSCI EAFE Index ETF (XEF): Track the MSCI EAFE index, a market-cap weighted index that tracks stocks from Europe, Australasia and the Far East (essentially an index of developed market stock markets excluding the US and Canada). MER is 0.30 percent. The ETF is a wrapper around the iShares Core MSCI EAFE ETF (IEFA).

iShares MSCI Emerging Markets ETF (XEC): Track the MSCI Emerging Markets Index, a market-cap weighted index that tracks stock market performance of emerging markets. MER is 0.35 percent. The ETF is a wrapper around the iShares Core MSCI Emerging Markets ETF (IEMG).

Take-away for Investors

  • These ETFs are great news for Canadian investors wanting Developed Markets ex North America and Emerging Markets exposure from securities listed in Canada but do not want currency hedging because the new ETFs are far cheaper than existing alternatives.
  • Investors should keep in mind that owning a Canadian-listed ETF that holds foreign securities in their RRSPs means incurring a 15 percent withholding tax hit on dividends. i.e. an investor who holds $1,000 worth of XUS in a RRSP will incur a tax hit of $3 per year compared to holding $1,000 worth of IVV. Note that the withholding tax hit is only for RRSPs and RRIFs.

Budget 2013 clamps down on Advantaged ETFs

April 9, 2013


Advantaged ETFs refers to exchange-traded products that use derivatives such as forward agreements to transform one form of distributions (often interest income) into another (such as capital gains or return of capital) that is lightly, if at all, taxed. For example, an investor holding the iShares Advantaged Canadian Bond Index Fund (TSX: CAB) in a taxable account will have received capital gains and return of capital equal to the income generated from a portfolio of Canadian Government and corporate bonds (less fees and expenses). Capital gains are taxed at half the marginal rate. If the investor had instead directly held the portfolio of bonds, the interest income would have been taxed at the investor’s marginal rate.

Budget 2013 proposes to put a kibosh on what it calls “character conversion transactions” such as the ones employed by Advantaged ETFs.

Character conversion transactions link a derivative investment with the purchase or sale of an otherwise unrelated capital property to form a derivative forward agreement. If the derivative investment were made separately from the purchase or sale of the capital property (i.e., as a cash-settled derivative financial instrument), any income from the derivative investment would be taxed as ordinary income.

To ensure the appropriate tax treatment of the derivative-based return on a derivative forward agreement, Budget 2013 proposes to treat this return as being distinct from the disposition of a capital property that is purchased or sold under the derivative forward agreement. This measure will apply to derivative forward agreements that have a duration of more than 180 days. Whether a particular property is held on income or capital account is largely a factual determination and is unaffected by this measure.

ETFs Affected by the Change

iShares Canada put out a press release saying that seven funds in its ETF line up will be impacted by the changes proposed in the Budget. It is interesting to note that all these ETFs used to be traded under the Claymore brand name. They are:

iShares Advantaged Canadian Bond Index ETF (CAB)
iShares Advantaged Convertible Bond Index ETF (CVD)
iShares Advantaged U.S. High Yield Bond ETF (CHB)
iShares Advantaged Short Duration High Income ETF (CSD, CSD.U)
iShares Global Monthly Advantaged Dividend Index ETF (CYH)
iShares Broad Commodity Index ETF (CBR)
iShares Managed Futures Index ETF (CMF, CMF.A)

ETFs Not Affected by the Change

Horizons also put out a news release saying that the Budget proposals are not expected to impact the popular Horizons S&P/TSX 60 Index ETF (HXT) because the ETF makes no distributions and hence there is no re-characterization taking place. Horizons confirmed that the Horizons S&P 500 Index ETF (HXS) is also not expected to be affected by the move. Nevertheless, investors should weigh the risk of an adverse change in tax treatment of swap-based ETFs against the tax advantage of earning total returns.

See also: Canadian Financial DIY’s and Canadian Couch Potato’s takes on this topic.

A look at the Performance of the BMO Covered Call Canadian Banks ETF (ZWB)

February 5, 2013


BMO launched its Covered Call Canadian Banks ETF (TSX: ZWB) in January 2011. The ETF immediately started attracting investor attraction. Investors were mesmerized by the initial annualized yield of 10% and piled money into the fund: among ETFs launched in 2011, ZWB ranked first by Assets under Management by a wide margin. Interestingly, the second most popular among ETFs launched in 2011 is another covered call product: the Horizons Enhanced Income Equity ETF (TSX: HEX). Investors had clearly developed a preference for income products.

It appears that many investors thought (or at least hoped) the higher yield from ZWB compared to a plain vanilla product like the BMO S&P/TSX Equal Weight Banks Index ETF (TSX: ZEB) would translate into higher total returns. Now that ZWB has a 2 year track record under its belt, we can analyze how ZWB’s returns stacks up against ZEB’s.

Performance for the 2-year period ending Jan. 31, 2013

BMO Covered Call Canadian Banks ETF (ZWB): 8.10%
BMO S&P/TSX Equal Weight Banks Index ETF (ZEB): 8.92%

We find that the Covered Call ETF under performs the Bank ETF by an annualized 0.82 percent over a two year period even though it is just 0.10 percent more expensive than the plain-vanilla ETF. In the following graphic, we break down the total returns from the two ETFs into income and capital gains.

Comparing returns from ZWB and ZEB

The one year performance (for the period ending Jan. 31) of the Covered Call Banks ETF (ZWB) is compared with that of the Equal Weight Banks ETF (ZEB) in the following table:

2012 2.84% 3.59%
2013 14.01% 14.52%

If we look at the income generated by these two ETFs as a percentage of starting NAV, we get:

Income generated for the 1-year period ending Jan. 31, 2012

BMO Covered Call Canadian Banks ETF (ZWB): 9.2%
BMO S&P/TSX Equal Weight Banks Index ETF (ZEB): 3.5%

Income generated for the 1-year period ending Jan. 31, 2013

BMO Covered Call Canadian Banks ETF (ZWB): 6.8%
BMO S&P/TSX Equal Weight Banks Index ETF (ZEB): 3.6%

In other words, though an investor earned a significantly higher current income with ZWB, she would have earned lower total returns compared to an investment in ZEB over the past two years. Also, the income an investor receives from the covered call ETF has been dropping: the fund started off with an annualized yield of 10 percent but two years later, the yield is just 5.6 percent. Granted, a two year time frame is too short to make a fair comparison of ZWB and ZEB but the early results show that just as we initially suspected, there is no free lunch here.

NB: This post was initially published on Feb 20, 2012. It was updated on Feb 5, 2013.