Foreign Income & Assets - Avoid Nasty T1135 Trouble

Hard-pressed governments everywhere are redoubling their efforts to find tax evaders, one of the prime targets being people who hide investments in distant tax havens. Splashy news like the recent CBC post Massive data leak exposes offshore financial secrets heighten the profile of the issue. Everyone should pay their fair share of taxes but innocent people who actually do pay all they owe can get caught in the crossfire through the strict rules put in place to catch cheats. The consequences can be nasty with penalties easily running into thousands of dollars.

Many situations can cause an investor to get exposed to and possibly caught in the tax penalty net:

• diversified portfolios that include foreign holdings
• inheritances from abroad
• immigrants to Canada who have retained foreign assets
• Canadians abroad who acquire foreign assets

There's one key form that investors need to check whether they need to complete and file, the innocuously titled Foreign Income Verification Statement Form T1135. As can be seen below, the form asks mostly about assets though there is a question about total foreign income.

(click on image to enlarge)

Here are some of the basics of the T1135, bearing in mind that we have summarized and the official source of the government pages, mainly the tax collector, the Canada Revenue Agency, contains more complete information. A tax accountant can be extremely useful to interpret and give guidance on "what ifs" and other scenarios not covered. In case of doubt, it is best to get professional advice since the bad consequences of being wrong are so severe.

Who is subject to the T1135?

• individuals corporations, trusts and certain partnerships,
• who is resident of Canada (which is not the same as being a citizen) and thus liable to file a tax return in Canada, keeping in mind that a resident has to declare all world wide income. Potential Gotcha #1 - even if you have no income or foreign income to declare, or your income is too low and you know there will be no income taxes to pay, you might need to file the T1135 by the tax deadline anyway since the criteria is based on assets (see Q1 of this CRA page).

What are the criteria for the T1135 filing requirement?
If the "who" above owned during the past tax year:

• specific foreign assets; "foreign" means either where the assets are held, or who issued securities, like stocks and bonds issued by non-Canadian / non-resident companies or governments. Potential Gotcha #2 - what's in and what's out can get tricky - any securities, including Canadian securities, on deposit with a non-Canadian broker are "foreign", as are any non-Canadian securities in a non-registered taxable account, including any that might happen to be traded on the TSX (see this list on TMX Money) but not a share of a Canadian company bought on a foreign stock exchange (there are many traded in the USA per this list on TMX Money)
• total value over $100,000 i.e. the sum of all assets together, not the value of any individual asset, but not counting any excluded property like what is in RRSPs and the like
• value at any time during the past tax year, not as of the filing date, so that an asset that was sold during the year counts towards the calculation
• cost, not the current market value so that investments bought for $80,000 and now worth $120,000 would be exempt
• dollars in Canadian currency, the conversion rate being that in effect on the purchase date or deemed acquisition date, such as when an immigrant becomes resident
• see more situations in the CRA Questions and answers about Form T1135 page

What must be reported?

• amounts in foreign bank accounts;
• shares in foreign companies;
• interests in non-resident trusts;
• bonds or debentures issued by foreign governments or foreign companies;
• interests or units in offshore mutual funds;
• real estate situated outside Canada; ... but this is only when it's primary purpose is not for personal use (see exclusion below)
• other income-earning foreign property.
• US Roth IRA (probably, unless the proposed change mentioned here came about to exclude Roth IRAs)

What foreign investment property is excluded?

• personal-use property, that is, any property used mainly for personal use and enjoyment, such as a vehicle, vacation property, jewellery, artwork, or any other such property; Potential Gotcha #3 - the vacation property exclusion gets tricky itself as it isn't cut and dried when a property is rented out part of the time to make a profit but is also mainly for personal use (see this answer in the CRA Q&A)
• assets used only in an active business, such as a business inventory or the equipment and building used in a business
• RRSP and other registered account - LIRA, LRIF, LIF, RESP, TFSA, RPP - holdings; though the CRA Q&A specifically mentions only RRSPs, the other types of accounts also presumably qualify for exclusion (which makes us wonder why the CRA would not want to be more completely explicit to avoid a lot of uncertainty amongst taxpayers); this provision lets out many if not most taxpayers from having to file the T1135
• Canadian mutual funds or ETFs that hold foreign stocks and bonds - a US resident ETF like ISHARES CORE S&P 500 ETF (NYSE symbol: IVV) is a foreign asset in a non-registered account but the iShares S&P 500 Index Fund (CAD-Hedged) (TSX: XSP) or the new non-hedged version XUS, both of which actually hold only IVV, would not be considered foreign since they are established in Canada. For more, read MyOwnAdvisor's excellent article on the T1135 with many examples of possible included or excluded assets.
• US Individual Retirement Accounts (IRA) and 401k

What are the penalties?
For not filing, or filing late, the penalties are severe per this CRA webpage, whether or not any foreign tax is owing or undeclared: $25 per day, up to $2500 per year, repeated for each year filing is missed, even when it is an innocent mistake (e.g. when all foreign income has been declared and tax paid!) is very harsh, as accountant The Blunt Bean Counter noted.

The CRA is unforgiving, as shown by the comments and laments on the T1135 Financial Webring thread, on this BritishExpats.com discussion, by this Advisor.ca post by Jamie Golombek on T1135-sparked court cases and another on a specific case where an honest first-time mistake did not escape the penalty. One lucky taxpayer did successfully fight the penalty but this more the exception than the rule. Potential Gotcha #4 - the fact that all foreign income has been declared and taxes paid does not excuse the necessity of declaring foreign assets and filing the T1135.

What to do?

• when in doubt, file the T1135; it seems that there are no penalties for sending it in even if it turns out not to be required; at worst the CRA may ask for more details on assets that aren't an issue. The CRA fillable and savable T1135 pdf is here ; incorporated instructions include the mailing address. Potential Gotcha #5 - right now the only way to file this form is by printing it out and mailing it in. The CRA's nifty electronic NetFile service does not include the T1135, though the CRA says it is working on making the T1135 electronically filable. Most of the NetFile certified software packages to prepare taxes aren't clear enough about the mailing requirement.
• buy Canadian-based mutual funds and ETFs in a non-registered account. This won't avoid the necessity of reporting for the past but it can avoid future hassles. As we noted above, such investments are not considered foreign property by the T1135 and there are plenty of fund alternatives for the main foreign asset classes. Though expense ratios are almost always higher than for US-based funds, owning a Canadian-dollar sold fund also avoids the cost and trouble of currency exchange and possible exposure to US estate tax.

With the April 30th deadline only a few days away, there's still time to comply and avoid unnecessary problems, even if your tax return has already been submitted. Figure out where you stand and take action.

Disclaimer: this post is my opinion only and should not be construed as investment or tax advice. This topic in particular can be complicated and it can have severe unwelcome consequences. The commentary rests on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Stock Market: Is it Sky Falling Again, Business as Usual or Spring Sale?

In the last few days we witnessed the Toronto Stock Exchange Composite Index fall sharply several days in a row, prompting some to worry e.g. this somewhat frantic news article. So, we asked ourselves, where are things, is this a major reversal, or just par for the course, part of the normal ups and downs of the market? The drop also triggered the thought to go look for stocks on sale at attractive bargain prices, such as we did in August 2011 during another significant drop.

Sky not falling, more like business as usual
A brief look at the Yahoo Finance chart below of the TSX shows us that the current decline is only one of many that have occurred over the past several years alone. It is not nearly the most severe or prolonged.

(click image to enlarge)

The fact is, the market does go up and down. The ride is never smooth. Our previous post on investing risk about volatility and business cycles gives us more context on what extremes we should expect. Being aware of such constant volatility helps us investors avoid panic reaction and allows us to sleep better.

Mining and Oil & Gas in a two-year funk
These two sectors have caused the sustained fall from the TSX high in April 2011. They comprise a significant portion of the TSX Composite. The charts from TMX Money of the Mining and Oil and Gas indices show the market price decline and the tables from Globe Investor's MyWatchlist show the falling profits at the majority of companies that have spurred the declines.

Mining

(click to enlarge)

Oil & Gas

Opportunity lurking?
As we also see in the tables, most of the companies are still profitable. A good number, like First Quantum Minerals (TSX symbol: FM), Agrium (AGU), IAMGold (IMG) and Katanga Mining (KAT) amongst miners, and Canadian Oil Sands (COS) and Imperial Oil (IMO) amongst energy companies sport very appealing low Price to Earnings ratios. Such indications of possible bargains need to be assessed further using the various accounting figures and ratios such as the Watchlist provides automatically.

At some point down the road, when exactly it is impossible to tell, these industries will revive with more vigorous economic growth in other countries who need the resources produced by these companies. Picking individual company stocks or buying a basket of companies in a sector ETF (find them using one of the ETF screeners we compared here). Or failing that, continuing to hold the broad TSX through a composite ETF that includes these sectors will eventually gain the benefit of a rebound too.

Spring sale on other stocks
Using the same filter as in the August 2011 post, we picked out the medium (above $500 million in market cap) to large cap stocks with more attractive P/Es of under 15 and appealing dividend yields of over 3% on the TMX Money stock screener. Then we copied various the stocks along with their data to a spreadsheet and found the potential bargains by calculating and ranking which stocks were most below their highest price of the past year. Along with that we calculated which were closest to their 52 week lowest price.

(click to enlarge) 

The result:

• There are still plenty of low P/E stocks paying attractive dividends - our table above shows the 30 largest companies only, which includes all the banks and several mining and and energy companies. Many have solid profitability (higher Return on Equity), though not as consistently growing sales or earnings. Most of the list is less volatile than the overall TSX, as shown by trailing 60 month betas below 1.0 (above 1.0 is more volatile than the market average).
• Price cuts are less today than 2011 - Price reductions off the highs are not as large as in 2011 when we compare the two lists
• There are fewer bargain stocks overall - our initial screen in 2011 gave more than 100 stocks while this time it was only 98

August 2011 bargain stocks generally fared well
When we looked at the results for the previous effort, they showed generally quite good outcomes:

• TSX Composite as a benchmark lost 1.9% in total return from August 2011 to 19 April 2013 (see GlobeFund chart)
• Eight of the twelve stocks at the top of the list had overall significantly positive returns (symbols BLS, BPO, SLF, MIC, POW, GWO, RY, HSE), three were around zero like the TSX (COS, PWF, IGM) and only one a big negative, Larbrador Iron Ore Royalty Corp (LIF.UN) which had its dividend haved and a 7.5% price drop. Interestingly, seven of these are on our new bargain list - COS, SLF, MIC, POW, GWO, RY and HSE)

Bottom line: Using such filters to seek out good buys amongst stocks generally points in the right direction, though not infallibly so.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Ways to Get Steady Dependable Income from Mortgages

Every adult Canadian knows what a mortgage is and understands that it is a loan against property on which interest must be paid regularly without fail or else there is risk of having the property taken over by the lender. Many of us are mortgage borrowers to buy a home at some point in life. If we put the shoe on the other foot as investors, mortgages can have a definite appeal as a steady income-producing investment that should be quite secure (how many people would easily or willingly default and lose their home?).

Let's look at the alternative ways a Canadian investor can buy into mortgages. Here is a comparison table of the key features of the alternatives we review below.

(click to enlarge image)

Mortgage Investment Corporations
MICs are specialty funds to pool investor capital for lending out as mortgages, primarily for residential buildings but with a portion allowed for commercial properties. MICs have a long history going back to the 1970s when the federal government modified the Income Tax Act (in section 130.1) to allow income from mortgage interest to be passed through tax-exempt in the MIC to individual investors for taxation in their hands. Average Joe, instead of paying interest on a mortgage on his home, can turn the tables, invest in a MIC, and collect interest instead.

More detail:
1) CanadianFinancialDIY's Ins and Outs of Mortgage Investment Corporations,
2) Interview about the origins and workings of MICs with Wayne Strandlund, CEO of one of the biggest private MICs Fisgard Capital Corporation on the Canadian Mortgage Trends.com blog,
3) Regulatory restrictions on who can invest in private MICs, which varies by province, also on Canadian Mortgage Trends.com
4) PIC-a-MIC, Fisgard's more-than-thorough 27 point due diligence checklist for investors. This checklist serves very well for any of the types of mortgage investments we discuss now.

Four MIC flavours - The tax-exempt MIC status can be, and is, available in four different types of corporate structures and investor vehicles.

• Private MICs - The investor deals directly with the MIC and are thus not available to the online investor. They are subject to the provincial regulatory restrictions. Private MICs tend to be smaller and more narrowly focussed on a province, or even a city. With private MICs you basically expect to get your original contribution back, unless there are bigger losses on the mortgage portfolio than the reserves the the MIC management (should) put in place. Your status is that of providing equity to the MIC, not a loan, so it's not like a GIC. The expectation is interest income/return only. There are dozens of private MICs across Canada, some of which CanadianFinancialDIY lists.
• Closed End Funds - There are only a few of these around - we found only two, the Timbercreek MIC (TSX symbol: TMC) and the Timbercreek Senior MIC (MTG) which holds an even safer bag of mortgages albeit at a lower return. CEFs are very convenient to the online investor since they can be bought on the TSX just like any other stock. They are subject to fluctuations in market price and so can create capital gains or losses in addition to the interest income.
• Investment Fund - Almost a CEF except it isn't redeemable, the First National Mortgage Investment Fund's (FNM.UN) days appear to be numbered after the recent federal budget which announced an intention to prevent the transformation of interest income into lower-taxed capital gains by funds such as this one. First National issued a press release denying FNM.UN will be affected so we will have to wait and see the final outcome.
• Public Corporations - There aren't many of these either. We found only three - Firm Capital MIC (FC), MCAN Mortgage Corp (MKP) and Atrium MIC (AI). They also trade like any other stock with capital gains/losses results too.

Public Corporation but not a MIC
This publicly-traded company concentrates on mortgages but does not have the tax status of the MIC.

• First National Financial (FN) - This is the same company that created FNM.UN. FN, however, isn't about to disappear anytime soon judging by its claimed status as Canada's largest non-bank mortgage originator and lender. Its business model is quite different from the MICs above. It doesn't just lend and collect interest, it sells on many mortgages while continuing to collect fees for administering them. Consequently its capital structure has lots of leverage but isn't necessarily more risky. Unlike MICs FN distributes dividends and possible capital gains to investors.

Mortgage Mutual Funds
There are several dozen (37 were found in GlobeInvestor Fund Lookup by typing in "mortgage" as a fund name search term). Such funds typically buy mortgages created by other companies and have a lot of lower yield guaranteed mortgages along with some short term bonds so their yield is less overall.

Mortgage REITs in the USA
The attraction of such funds within registered retirement accounts (RRSPs and the like but not TFSAs or RESPs) is that no tax is payable, not even US Witholding tax). These funds sport very high 12-18% cash payout yields at the moment which looks great but is a strong clue of much higher risk. That risk comes from a business model (see description in the Wall Street Journal) much different to any of the Canadian options above. The mortgage REITs rely on the return boosting effect of borrowing at very low short-term rates to buy mortgage backed securities (basically bundles of mortgages originated and sold on by other firms). Are these yields sustainable? One Seeking Alpha article thinks yes, for some. In addition to the many individual mortgage REITs, ETFdb lists US ETFs that hold mortgage backed securities.

Portfolio Considerations
Mortgage interest-producing investments fall into fixed income and their current relatively high yield compared to GICs or short term bonds can make them an attractive alternative.

All but one - the exception being First National - of the securities produce income that is taxed as interest despite the misleading name of dividends attached to the distributions. Therefore the best place to hold such mortgage securities is in a RRSP, TFSA, RRIF, LRIF, LIRA or other tax-favoured account.

Payout Stability and Yield
As our table below shows, the cash payouts of the MICs with a longer track record have declined along with interest rates. That's not necessarily a bad thing since they still compare favourably with other short term fixed income as we have already noted. 

(click to enlarge image)

The key to the future is the skill and judgement of the mortgage management team in properly adjusting the risk of the mortgage lending to the interest rate charged while controlling costs and the risk of leverage. To assess that and other factors that can affect the success of a mortgage, it is a wise idea to use the checklist we mentioned above. As usual, the return to be expected, whether it is interest or dividends and capital gains, will be related to the riskiness of the investment. 

Is now a bad time to invest in mortgages?
That's a natural question given the slowdown in sales in a number of markets and some reports of impending doom in the Canadian market akin to what happened in the USA and other countries. Of course, the companies say they are still expanding profitably within acceptable risk parameters due in part nowadays to some pullback in lending by the big banks. In our opinion it's too hard to tell if mortgages are a better or worse investment than anything else right now. The best protection lies in the due diligence to pick the solid companies who can survive in bad times as Canada's banks did through the 2008-09 financial crisis.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Canadian Dividend ETFs Update: How does newcomer Vanguard's fund compare?

After we wrote our original comparison last July about Canadian ETFs that focus on dividend paying stocks, fund giant Vanguard entered the fray in December 2012. Let's see how its fund compares to the existing bunch of ETFs in this category while providing some additional perspectives and updates to the previous analysis.

The ETFs

• iShares Dow Jones Canada Select Dividend Index Fund (XDV) - this dominant fund reinforced its lead in the category and total assets now stand at $1.2 billion
• iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (TSX symbol: CDZ) - still second most popular fund with $867 million in assets
• iShares S&P/TSX Equity Income Index Fund (XEI) - yet another dividend ETF from iShares, assets up $50 million to $156 million
• Horizons Dividend ETF (HAL) - more than 2 years on the market yet still tiny with only $11 million in assets
• BMO Canadian Dividend ETF (ZDV) - BMO's version has made good headway garnering over $100 million from investors to reach $160 million in total assets
• First Asset Morningstar Canada Dividend Target 30 Index ETF (DXM) - still gaining no traction at $6 million in assets
• PowerShares Canadian Dividend Index ETF (PDC) - another laggard since its launch in June 2011 with only $11 million in assets
• *New* Vanguard FTSE Canadian High Dividend Yield Index ETF (TSX symbol: VDY) already up to $19 million in assets after only 4 months, probably because, true to form for Vanguard as a low cost leader, VDY's MER set a new low for dividend ETFs of 0.35%

 
(Click on image to enlarge)

Cash Distribution Yield - payouts are not necessarily stable or always growing
As in July, XEI still offers the highest cash payout yield of 4.6% (based on the trailing twelve months) but the gap with ZDV and XDV has narrowed. HAL still does worst, offering only a bit more at 3.0% than the TSX market average, seen in the broad market ETF from iShares (XIC), of about 2.5%. VDY's poor 2.2% yield we interpret as being being a temporary effect of the recent startup.

(Click to enlarge)

The reason we think it is temporary is an additional metric we found on Morningstar.ca where the Portfolio details page shows the projected dividend yield of the combined holdings of an ETF. VDY's is here and it shows as 4.27%. The number is not a forecast since MER, trading costs, index changes, imperfect tracking or dividend changes will cause actuals to fall short but it is a suggestive indicator. ZDY comes out ahead on the forward-looking dividend yield. DXM and PDC's numbers suggest continued more modest payouts though still ahead of our market benchmark XIC's projected 3.04%.

Surprisingly, some of these ETFs hold a good proportion of stocks that have cut their dividends. About 20% of the stocks in both XEI and VDY have lower dividends today than five years ago, which we discovered when we entered the stock symbols for all these ETFs in the free GlobeInvestor My WatchList and displayed the Dividend view. To be sure we didn't exclude stocks that had cuts during the credit crisis but have since got back on track, we did not count those which have increased dividends in the past year even though they had a negative five-year record. The selection method itself for XEI and VDY - based mainly on high dividend yield - may expose them to more volatile dividends and payouts. Whether the offsetting diversification benefit of the ETFs' many holdings is enough to overcome this factor, only time will tell but it cannot be helpful. Funds like CDZ and PDC both are built on selecting only stocks with rising dividends, which eliminates the problem.

Even that is not the end of the story, however. CDZ has a longer track record back to 2006 and we can see in the graph below that CDZ's distributions fell considerably through 2010 and 2011 before going back up somewhat in 2012. The reason is its particular selection criteria which requires that its stocks have rising dividends. As Canadian Couch Potato explains in this post, after the financial crisis the big banks stopped raising their dividends and these stalwarts of CDZ were cast out causing the ETF to shrink in number of holdings and in cash distributions. Meanwhile the investor in XDV, with its looser criteria requiring only avoidance of stocks cutting dividends, fared much better. Distributions fell much less and are up strongly since 2007.

(Click to enlarge) 

Payout Ratios Point to Stronger Future Dividend Growth?
In the 2003 paper Surprise! Higher Dividends = Higher Earnings Growth published in the Financial Analysts Journal, Robert Arnott and Clifford Asness found that in the USA, stocks with higher dividend payout ratios (i.e. higher dividends as a proportion of earnings) had higher future profits. It was not yield - dividends as a proportion of stock price - that mattered but the ratio to earnings. For stocks that experience strong earnings growth, higher dividends are likely to follow too.

On the assumption the pattern will hold in Canada too we have calculated the weighted average payout ratios for these ETFs also using figures from the Globe WatchList view and find that ZDV and XEI sport the desirable higher payout ratios. DXM's is quite low at 31% while VDY's is next lowest at 35%.

Stock and Sector Concentration
As before XDV and PDC remain too heavily concentrated in a few stocks and in the financial services sector. Surprisingly for a fund that holds the most stocks of any of these ETFs, VDY joins them with 61% of its holdings in the top ten stocks and a 59% overall concentration on financials.

The other ETFs' sector restrictions bring them much closer into line with the overall TSX embodied again by XIC, which has only 34% in the top ten and 33% in financials.

(Click to enlarge) 

Volatility Riskiness and Performance
Only a few of the ETFs have a long enough track record to get an inkling of their market volatility and performance but they seem to tell the same story. Volatility of market price over the past three years (again obtained from Morningstar) is markedly lower at 8.3 - 8.7% than XIC's 10.7%.

Total returns (dividends plus price appreciation) over both the past three and five years are well ahead of the XIC average, respectively, of 3.2% and 0.7%. What CDZ lost in cash payouts it more than made up in capital gains with total return of 9.4% over 3 years and 6.3% over 5 years. The story of dividend ETFs is not just dividends.

(Click to enlarge) 

Though much too short to be in any way definitive, these are encouraging signs supporting the basic idea mentioned in our first post of dividend stocks as providing superior stability and better returns.

Bottom line
We still think that ZDV wins our vote with its much lower MER, high payout ratio and good diversification through low concentration across companies and sectors. HAL is still worst with its high MER, low dividend payout and un-dividend investing strategy. CDZ is well diversified but its MER is quite high and its yield is still not far above the TSX. XEI pays the highest yield and it is reasonably well diversified but it has a fairly high MER and includes a high proportion of dividend-cutting companies. DXM is well diversified but its MER is on the high end and the payout ratio of its holdings is quite low. With their poor growth in assets we wonder whether HAL, DXM and PDC will be able to survive long. XDV and PDC are still too concentrated in the financial sector and in a few companies. Newcomer VDY has joined them in that regard and it also includes too many companies that have cut dividends, offsetting its attractively low MER.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor. 

High Cash Distribution ETFs - How sustainable are the payouts?

Last week we looked at the ETFs that distributed the most tax efficient cash income to investors during 2012. We discovered that several of the highest cash dispensers suffered from the unwelcome and unhelpful feature of giving investors some of their own capital back - what we call bad Return of Capital. This week we look at another aspect of the high-yielders - what influences the continuation of the high payout for these ETFs and how sustainable the cash distributions are likely to be in future.

Covered call option ETFs
Many of the highest payout ETFs depend on the extra income generated by writing covered call options on the portfolio held by the ETF. As Vikash Jain explains in the Financial Post, it's a method that works well under certain market conditions - a market that rises sluggishly.

• Horizons Enhanced Income Equity ETF (TSX symbol: HEX)
• First Asset Can-60 Covered Call ETF (LXF) 
• Horizons Enhanced Income Financials ETF  (HEF)
• BMO Covered Call Canadian Banks ETF (ZWB)
• BMO Covered Call Utilities ETF (ZWU)

(click image to enlarge)

As our comparison table shows in the orange background cells, such ETFs need to have as much or more income from such call writing, or from unrealized capital gains, as from the dividends of the under-lying portfolio in the ETF, to sustain their high distributions. That such a strategy doesn't always work was demonstrated in 2012 when four of these ETFs, shown by their names in red on the table, ended up giving back investors some of their own capital to maintain the high payout.

(Dis)Advantaged ETFs
These ETFs, of which one is in our table, the iShares Advantaged High Yield Bond ETF (CHB), have been turned into disadvantaged funds by the federal budget last week, which announced the intention to disallow the transformation of interest income from bonds into lower-tax rate capital gains. Even were this not the case, the much lower yield of the underlying bond portfolio would not have permitted CHB's high payout to continue for very long.

Diversified constant cash payout ETFs
This type of ETF holds a diversified balanced portfolio of common shares, mixed with bonds and preferred shares, out of which it pays a constant monthly amount. The cash payout is higher than the dividends and interest given out by the under-lying portfolio so the ETFs depends on some capital appreciation to meet distributions.

• iShares Canadian Financial Monthly Income ETF (FIE)
• iShares Diversified Monthly Income (XTR)

The susceptibility is to market downturns, as XTR showed when it had to distribute a lot of return of capital in 2009. Will that happen again? That has happened only in one year since XTR was launched in 2005. XTR's required capital return over the portfolio's own yield is much less than FIE's so we would judge the cash distribution to be much less at risk of being cut.

ETFs that distribute only what they receive
The remaining high payout ETFs are diverse in their holdings - one is a dividend focussed equity, one holds preferred shares, two hold REITs and one holds high-yield junk bonds. Their distributions will vary year by year according to the market success of their particular portfolio.

• iShares S&P/TSX Canadian Dividend ETF (CDZ) - payouts are fairly volatile, up as much as 21% or down by 26% from year to year
• S&P/TSX North American Preferred Stock Index Fund (CAD-Hedged) (XPF)
• BMO Equal Weight REITs Index ETF  (ZRE)
• iShares S&P/TSX Capped REIT Index (XRE) - generally stable payouts except for a big drop in 2009, which has not yet been fully recovered
• BMO High Yield US Corporate Bond Hedged to CAD Index ETF (ZHY) - payouts likely to decline as cash out exceeds yield to maturity by a fair amount

Paying out only what income they receive is also how the broad market equity ETFs, which we have included for comparison of their much lower cash distributions, operate with respect to distributions. The cash distribution of the ETF with the longest track record, the iShares S&P/TSX 60 Index Fund (XIU) has been quite resilient against reductions. Through the 13 years of its existence, spanning both the tech bubble bursting and the credit crisis crash, XIU's distributions have never been down more than 10% year over year, nor down for two years in a row.

High cash payouts now vs long term growth of distributions
As we wrote about in this post, in the long term, cash distributions from broad equity and dividend ETFs have tended to rise. The immediate pleasure of high payout funds may be outdone in the long term through funds that offer growth of the payout. For example, one of our high payout funds XRE's cash distribution is a bit lower than it was in 2003, the first full year after its launch, while XIU's are up 50% since then.

Perhaps that is the overall lesson we draw from these various ETFs. There is no magic in investing. When there is a seemingly higher reward, there is some lurking volatility or some potential downside.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.