However, the first job is to find the funds. One place to start looking for such ETFs is a website like Best Dividend ETFs which posts a list of Dividend ETFs with Domicile in Canada that currently distribute a lot of cash. We've taken that list and added other funds that looked promising. Other promising funds can be unearthed by looking through the tax breakdown for the previous year that the ETF providers publish every year around this time for their own ETFs. The trick is to look for ETFs that have handed out tax efficient income, starting with return of capital (ROC), then dividends and capital gains. Interest income and foreign income are taxed at the highest marginal rate so those types of funds are less likely to distribute a lot after-tax.
To assess the best after-tax net return, we gathered data for ETF performance over the year 2013, incorporating three factors: i) the pre-tax payouts, ii) the tax breakdown of distributions as published by the ETF providers and iii) the tax rates that apply to return of capital, dividends, capital gains and foreign or interest income.
Today's post updates the review we did last year in two posts - first, on the net returns in 2012 and second, on the likely sustainability of their high payouts. Redaders will note that many of the same high payout funds are on this year's list but that doesn't necessarily mean they are good choices.
The High After-Tax Payout ETFs
In the comparison table below, the results show how much cash return was received by an investor in the second highest Ontario tax bracket - $135,000 to $509,000 - or in a middle income bracket - $70,000 to $79,000 - in percent yield and in amount retained per dollar of cash received. There are some differences in ranking of the funds since higher rate taxpayers pay less tax on capital gains than on dividends while the reverse is the case for the middle income person, but the order is roughly the same.
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Many of the top payout funds in 2013 relied on bad Return of Capital (ROC) - The table highlights in red text the bad-ROC ETFs where the high tax efficiency and payout consists of large dollops of ROC and where the fund endured a net decline in Net Asset Value (NAV). As we have written in the past in the above linked posts and in the ever-popular Return of Capital: Separating the Good from the Bad, an ETF that merely pays an investor back his or her capital is not providing worthwhile performance.
Several other top payout funds have lost their advantaged edge - The grey shaded cells show the funds that last year lost their tax advantage when the federal government budget invalidated the transformation of interest income into capital gains by use of a forward agreement. Some funds ended the forward agreements later in 2013, like CVD, and others like CSD, CHB and HAF have adopted a transition strategy that uses the grandfathered existing forward agreement till expiry. Despite being allowed to continue for that limited time, their tax benefit will nevertheless be progressively diluted as new subscriptions enter the fund gaining normal interest that will be distributed as such to all shareholders old and new alike.
Call option revenue underlies a handful of high payout funds - Five funds - LXF, HEX, ZWU, ZWB and HEF - rely on revenue from writing covered calls on their portfolio holdings to generate tax efficient extra income for distribution to shareholders.
Call option revenue is treated as capital gains but several of the ETFs in the table have no capital gains but lots of ROC. BMO's ETF Taxation background document explains how this happens: "From a tax perspective, the gains from writing options are combined with gains and losses from trading the underlying portfolio. If the underlying portfolio trades have generated losses, these losses reduce or negate the tax gain from the written options and create ROC." When that occurs, the fund may only be distributing cash equal to the sum of call writing income and dividends, but the NAV capital loss portion from trading losses is bad ROC.
Rising markets are key for a couple of high payout funds - Two funds - FIE and XTR - pay out a pre-set steady stream of cash that is partly based on unrealized capital gains, and thus becomes return of capital, from increases in the market value of holdings. In years when markets decline the ROC will be bad and in up years like 2012 and 2013, the ROC will be good. Long term success depends on markets rising more than they fall over the years.
Dividend stock focus explains the last group of high payers - Our table of the top 15 best after-tax payouts contains three funds whose high cash distribution depends on a portfolio of stocks paying healthy dividends - ZDV, ZUT and XEI. The funds merely pay out what they generate.
Major Canadian Index ETFs are tax efficient for middle income investors but not nearly as much for high bracket earners - For comparison we compiled the same data for some of the most popular Canadian equity index ETFs. The first thing we note is that generally the net after-tax payouts are much more modest, in the 2- 3% range across both income tax brackets. But the tax efficiency in terms of amount of each pre-tax dollar retained after tax is much better for the middle income earner, around 86 cents on the dollar, than for a a high bracket investor. The index funds mainly pay out dividends, which are taxed less in the middle income investor's hands.
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There is not much difference in efficiency between the highest cash payout funds and the index funds for the middle income investor. There is a great deal more difference for the high income investor - 72 cents on the dollar retained from the index fund payout vs as much as 90+ cents. The high payout funds with high efficiency are a much more appealing proposition for high earners.
Sustainability of cash payouts is a challenge for most high payout funds - Our next comparison table calculates the gap between the payout rate and the amount of income the holdings generate in dividends or interest net of MER. We have highlighted in salmon colour those ETFs where there is a substantial shortfall that must be made up somehow to avoid paying out bad ROC.
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Covered call writing ETFs need to generate the extra revenue primarily from the call writing. As we have discovered through seeing long term declines in NAV at most of these funds, it isn't easy. LXF, HEX, HEF and ZWU have all failed so far and suffered falling multi-year NAV. Only ZWB has managed to hold its NAV at least level.
But that ignores another key issue - ZWB is falling well short in total return performance. Compared to another ETF composed entirely of financial stocks, the iShares S&P/TSX Capped Financials Index Fund (TSX: XFN) it has exhibited the flaw discussed by Rob Carrick in the Globe when the flurry of covered call ETFs were launched in 2011, namely that they are more or less fully exposed on the downside but only capture a portion of the upside. XFN's one year total return to the end of February is 18.5% vs only 12.7% for ZWB.
Two other funds - FIE and XTR - rely on a rising market to generate capital gains that are distributed unrealized to shareholders as ROC. This works in the long term and cash payouts are sustainable, as long as markets rise more than they fall. Some years the constant payouts the ETFs have set will exceed gains, or the market will go down, and the funds distribute what is hopefully temporarily bad ROC, to be caught up when the market goes back up. XTR was launched in 2005 and survived through the
financial crisis so maybe it is a viable strategy. Its five year total return of 17.0% to the end of February even handily beat the 13.7% of a common benchmark fund, the iShares S&P/TSX 60 Index Fund (XIU) . There is a tax advantage to receiving immediately non-taxed ROC (which is taxed later as capital gains when the investor sells the shares) so such a fund can make sense for taxable investors who want cash now.
Finally there are the funds holding dividend stocks like ZDV and XEI, which only distribute what they actually receive from the holdings, i.e. mostly dividend income. We had to cut the table off for lack of space but other dividend ETFs (reviewed recently here) like XDV, PDC, PDF are not far behind. Other funds with higher payouts that similarly only distribute what they receive like REITs and preferred share holding funds are also not far behind.
Bottom line - High payouts often come with the downside that more cash now means lower long term returns. Funds that distribute only what the under-lying portfolio generates naturally have a much better prospect of long term sustainability. As the old expression goes, it's not possible to make a silk purse out of a sow's ear.
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.