CE Course: An in-depth look at ETFs, Part 1

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“An in-depth look at ETFs, Part 1” is eligible for CE credits, see Accreditation details for more information.

The questions for this course were written by Mark Yamada, President & CEO of PŮR Investing Inc., a registered portfolio management and software development firm specializing in disruptive strategies for investors, their advisors and pension plans.

PART 1: How to make accountants smile

Investing in ETFs has positive tax implications

By Ioulia Tretiakova

Low turnover and in-kind transfers have made ETFs popular with tax-conscious investors and their advisors. Choosing an ETF over a mutual fund generally provides immediate cost and tax savings, but there are additional ways to enhance after-tax returns using ETFs.

Keep distributions low

Lower distributions generally mean higher after-tax returns because more capital is available to compound. When selecting an ETF, advisors should consider their client’s tax status.

The ETF Screener on the TMX Money website compares the tax efficiency of various ETFs, a benefit that’s estimated as the proportion spent on taxes with appropriate tax rates applied to income, capital gains, dividends and return of capital distributions.

Structural vigilance

Some ETF manufacturers embed structures into their funds to make them more tax-effective. This involves an added layer of cost. An example is Claymore’s Advantaged Canadian Bond ETF (CAB) that structures payouts as a return of capital. CAB’s 4.17% return is almost 1% lower than the 5.14% return for its benchmark, the DEX DLUX Capped Bond Index (from inception November 19, 2009 to December 31, 2010).

However, the fund’s stated MER is only 0.33%. Claymore says, “The difference in returns between the Index and ETF is principally due to fees and expenses.” The prospectus reveals the fund pays the counterparty an amount under a forward agreement up to 0.45% per annum of the forward amount. Depending on an investor’s circumstances, the tax advantage of receiving distributions as return of capital may or may not exceed the added layer of cost in these products.

Peculiarities of withholding tax

In most cases, buying a Canadian ETF that holds U.S. ETFs means losing the withholding tax charged on the U.S. distributions. The tax is withheld on a fund level, making it impossible to claim the tax credit even in a registered account.

This amount could be meaningful, particularly for high-income-paying ETFs like iShares U.S. High Yield Bond (XHY), which usually gives up 15% of its 7% distribution yield to tax, reducing overall investment return by over 1%.

However, a change occurred last year, as noted by iShares. The U.S. Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which was retroactive to January 1, 2010, reinstated the U.S. withholding tax exemption for qualifying income distributed by the relevant Regulated Investment Companies to foreign entities.

As a result, when any ETF manufacturer reclaims the tax, investors can get back most of the amount paid by an ETF in 2010-2011. According to iShares’ June financial statements, not only did XHY reclaim a portion of 2010’s withholding tax, but the tax on 2011 distributions amounted to 0.40% instead of the previous 15%. According to iShares, “The exemption will currently expire for tax years beginning after Dec 31, 2011.”

Watch derivative structures

Investors in a U.S.-based Rydex fund received an 87% capital gains distribution in 2008 as a result of expiring futures contracts and prevailing market volatility. Canadian derivative-based ETFs seem to be unaffected.

Horizons BetaPro commented that derivatives contracts maturing in 2012 are likely to be extended without tax consequences. In general, derivative strategies can introduce collateral and counterparty risk to ETF analysis.

Tax-loss harvesting

ETFs provide exposure to various asset classes with similar risk profiles. This creates an opportunity for tax-loss harvesting.

For example, an owner of iShares S&P/TSX 60 (XIU) with an unrealized capital loss could sell and immediately buy iShares S&P/TSX Capped Composite (XIC), harvesting a valuable tax credit while staying invested in Canadian equities. While the two ETFs are similar in terms of performance (save a “Nortel effect” where one stock outperforms the rest of the index, when the capped XIC would perform very differently), they track separate indices.

To avoid swapping ETFs based on the same underlying index, an advisor could use a risk model to identify “risk twins,” or ETFs that could be used interchangeably. Another example is BMO S&P/TSX Equal Weight Oil & Gas Index (ZEO) and iShares S&P/TSX Capped Energy Index (XEG).

More risk twins can be found in the table below, “Examples of risk twins for tax-loss harvesting.”

In any core/satellite portfolio, a passive core could generate tax losses to offset realized capital gains from active satellite strategies.

ETFs offer after-tax opportunities in addition to their inherent tax efficiencies. Some synthetic ETFs (an ETF that uses derivatives) offer investors and their advisors effective ways to manage tax but also introduce new risks (see Part 3, “Abandoned briefcase at the airport”). Carefully managed, ETFs offer ways to create tax flexibility that can make investors’ accountants smile.

Examples of “Risk Twins” for Tax Loss Harvesting
iShares S&P/TSX 60 Index Fund (XIU)	iShares S&P/TSX Capped Composite Index Fund (XIC)
iShares S&P/TSX Capped Composite Index Fund (XIC)	Horizons BetaPro S&P/TSX 60 Index ETF (HXT)
Horizons BetaPro S&P/TSX 60 Index ETF (HXT)	iShares S&P/TSX 60 Index Fund (XIU)
Horizons BetaPro S&P/TSX 60 Index ETF (HXT)	Claymore Canadian Fundamental Index ETF (CRQ)
iShares S&P/TSX Capped Energy Index Fund (XEG)	BMO S&P/TSX Equal Weight Oil & Gas Index ETF (ZEO)
iShares S&P/TSX Capped Financials Index Fund (XFN)	BMO S&P/TSX Equal Weight Banks Index ETF (ZEB)
iShares S&P 500 Index Fund (CAD-Hedged) (XSP)	BMO US Equity Hedged to CAD Index ETF (ZUE)
Claymore Broad Emerging Markets ETF (CWO)	iShares MSCI Emerging Markets Index Fund (XEM)
iShares MSCI Emerging Markets Index Fund (XEM)	Claymore BRIC ETF (common class) (CBQ)
iShares DEX Universe Bond Index Fund (XBB)	Claymore Advantaged Canadian Bond ETF (CAB)
Claymore Gold Bullion ETF (CGL)	Horizons BetaPro COMEX Gold ETF (HUG)

PART 2: Adapting to changing needs

ETFs in actively managed portfolios work well

By Mark Yamada

ETFs are primarily associated with indexed or passive products, so the idea of combining them with active management seems as logical as U.S. Tea Party Republicans working with Democrats in Congress.

But institutional portfolio managers are pragmatic. They’re always looking for ways to improve performance, and ETFs offer an expanding arsenal.

Opportunities to improve portfolio function come under two categories: liquidity and diversification.

Liquidity

ETFs are changing the rules of portfolio management, and have added a dictum of their own—“it’s all about the underlying.” ETFs are a function of their underlying holdings. If these holdings trade well, the ETF should be liquid, which should be reflected in a lower bid-ask spread from market makers and a lower tracking error from the index it follows.

However, ETFs also offer a unique creation and redemption feature that allows market makers to create more ETF units if demand exceeds supply, and vice versa. This boosts liquidity beyond the traditional daily trading volumes that are reported.

To portfolio managers, this means an added element of liquidity for moving into or out of markets or sectors quickly with minimal trading impact. This function is useful if a manager has portfolio exposure to individual holdings that may not be liquid and wants to gain or shed exposure quickly. Exposure to other assets can be realigned later.

During the financial crisis of 2008-2009, when financial stocks could not be shorted, financial sector ETFs could be, adding liquidity to a market that desperately needed it. The chart “How U.S. asset managers use ETFs” shows institutions use ETFs primarily for the liquidity they provide.

Trend-following strategies (formerly known as market timing) have become increasingly sophisticated with the aid of computers. Some of these strategies form part of the algorithmic trading subculture. Traders need volatility to make money. Theoretically, because traditional ETFs dampen volatility, they are only useful for hedging.

However, leveraged ETFs are popular because of their added risk and often account for over 50% of all daily ETF trading volumes on the TMX. If active management involves aggressive trend following, leveraged ETFs can offer the needed juice.

Diversification

Diversifying to manage risk can be problematic, as the tech wreck of 2000-2001 and the financial crisis of 2008-2009 proved. Nevertheless, identifying the next uncorrelated asset class occupies the time of many professionals.

ETFs offer fertile ground for prospecting. Domestic and international equities draw the most institutional interest. In a 2011 Greenwich Associates study of asset managers using ETFs in the U.S., 89% used ETFs in their domestic equity portfolios and 94% accessed international equity exposure in whole or in part using ETFs.

Given recently elevated levels of market volatility, there is increasing buzz around exchange-traded products that represent volatility, like the iPath S&P 500 VIX Short-Term Futures Exchange Traded Note (VXX), the Horizon Betapro S&P 500 VIX Short-Term Futures ETF (HUV) and leveraged version (HVU). Because volatility tends to expand in declining markets, buying these ETNs can partially offset losses.

Caveat: Extended periods of volatility may mean that shorting leveraged versions would be preferred, so seek expert advice first.

Advisors

Advisors can use ETFs for all the liquidity functions listed in the chart, like cash equitization and transitioning from an old to a new portfolio. Portfolio completion involves finding assets that round out a portfolio based on the manager’s criteria. They may include hard-to-access regions like emerging markets or a particular maturity segment of the yield curve. Some tools allow advisors to enter an existing portfolio of mutual funds and/or stocks and bonds, and yield a list of ETFs that can replace the funds or improve the diversification properties of the portfolio.

Building a passive core using ETFs that represents the client’s long-term goals can also combine passive with active. Individual stocks, bonds, ETFs or funds can be chosen that represent active satellite bets. The core will reliably deliver the return of the long-term asset mix while the tactical pieces can be alpha-seeking, with costs optimized for the investor.

Money management is evolving to accommodate changing capital market demands. Passive buy-hold-rebalance strategies, while still defensible for pension and institutional portfolios with long investing time horizons, are proving to be inappropriate for individuals who face perpetually shortening horizons.

ETFs offer institutions, advisors and individual investors an effective and economical way to shift assets to tactically adjust for these evolving circumstances.

ETF Applications in U.S. Asset Manager Portfolios

PART 3: Abandoned briefcase at the airport

How dangerous are synthetic ETFs in Canada? No one knows

By Mark Yamada

Concern about ETFs started with leveraged ETFs during the 2008-2009 downturn. They disappointed investors who didn’t understand the impact of volatility disclosed in prospectuses. Then the May 6, 2010 flash crash sent the Dow Jones Industrial Average plummeting 9% before it immediately recovered. ETFs were suspected but have been exonerated. The recent £1.3-billion trading loss by a director of UBS’s ETF and Delta 1 trading desk has rekindled the debate.

How real is the problem?

Much like an abandoned briefcase at the airport, nobody knows for sure. No ETF has caused a meltdown of the financial system.

The problem is international banks, acting as counterparties for swap-based ETFs, have questionable balance sheets and may be too close to the sponsors. The result has been collateral with uncertain pedigree. Collateral adequacy is also a question for the widespread practice of securities lending.

Interest in ETFs has grown exponentially. Transparency, flexibility, tax efficiency and low cost have made them popular with institutional and retail investors alike. ETF construction is varied, some holding securities and others using derivatives. Within each of these groups there are further variations.

Things that cost too much or too little need to be watched more closely. The ETF Screener on the TMX Money website divides all ETFs into two types:

• Passive strategies: capitalization-weighted full replication—hold securities in the exact weight of their conventional target index.
• Embedded strategies (everything else): includes leveraged and inverse, active, style-based, equal weight, and others that use derivatives. All of these involve additional costs from rebalancing, forward or swap contracts, and some are subject to counterparty risk, that demand additional scrutiny.

The industry’s wake-up call was suggested by the Financial Services Authority—the U.K.’s version of the Securities and Exchange Commission—to ban or restrict retail purchases of swap-based ETFs.

This is like an outright ban on smoking, lottery tickets, unpasteurized cheeses or spicy foods. All come with risks, but for a regulator to suggest it knows better than consumers is alarming. So alarming, in fact, that BlackRock has called for voluntary industry changes in five areas: product labelling; holdings and exposure to derivatives disclosure; diversification of counterparties and collateral quality; uniform cost disclosure; and universal trading standards and reporting.

BlackRock may have much to lose if restrictions are imposed. But its competitors—several more aggressive in their derivatives use—have more at stake. Transparency remains key.

How much risk in Canada?

The chart “Global synthetic ETFs” shows ETF asset exposure to synthetics as at December 2010. Under 10% is green, 11% to 30% is yellow, over 30% is red. Also shown are percentages of synthetic ETFs to all ETFs. Canada has only 6% of ETF assets in synthetics. Twenty-nine percent of all ETFs have synthetic structures, according to Pat Chiefalo at the National Bank, who provided data.

European clustering is evident, particularly in the largest markets, Germany and France. Given the European Union’s challenges, exposure to undisclosed bank counterparty risk is concerning. Swap transactions are the most potentially toxic structure because of counterparty risk and lack of mandatory collateral disclosure. In Canada, there are three swap structures: Horizon S&P/TSX 60 Index ETF (HXT), its USD clone (HXT.U), and the Horizon S&P 500 Index Canadian dollar hedged (HXC). All are 100% collateralized with cash.

Could Canada get worse?

When an ETF’s sponsor and counterparty are the same, less liquid collateral may slip into the mix and adequacy may not be a priority when dealing with a colleague at the water cooler. If a bank decided to act as counterparty for its own swap-based ETF, there would be potential for abuse.

The remedies suggested by BlackRock and others calling for disclosure of collateral and counterparty relationships with standards of diversification of collateralized assets are sound.

Disclosure has made ETFs popular; that should be extended to collateral with limits to self-dealing. Derivatives can benefit investors, so it would be a shame if regulators denied access. Regardless, caveat emptor.

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