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)

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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.