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A deep dive into a global dividend ETF

jheinzl@globeandmail.com

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One of my recent Investor Clinic videos on dividend ETFs prompted this query from a reader:

"I'm wondering about your thoughts on an international dividend ETF such as the Claymore Global Monthly Advantaged Dividend ETF. I like the idea but the ETF forward agreement structure seems complicated and scares me off a little." - Jeff in Ottawa.

Well, Jeff, ask and ye shall receive, for today we'll take an in-depth look at that very ETF. You're right, it's a bit complex, so I've asked Claymore chief executive officer Som Seif to help us navigate the structure. I've also run some of the details by a derivatives expert to get his opinion. So let's dig right in, shall we?

THE BASICS

The Claymore Global Monthly Advantaged Dividend ETF is an exchange-traded fund designed to track the Zacks Global Multi-Asset Income Index. The index comprises about 250 companies, including dividend-paying stocks, real estate investment trusts, master limited partnerships, preferred shares and income trusts.

The weighting is about 40 per cent U.S. companies and 60 per cent international, including 9 per cent from Canada. Zacks uses a proprietary methodology to choose companies with "potentially high income and superior risk-return profiles."

You'll find plenty of well-known names here - Kraft Foods, Johnson & Johnson, Adidas - and some not-so-familiar ones - Portugal Telecom, Yanzhou Coal Mining.

The ETF hedges its exposure to U.S. dollars to minimize the impact of currency fluctuations for Canadian investors.

WHAT IS THIS FORWARD AGREEMENT THING ANYWAY?

For tax reasons, Claymore uses a derivatives contract with National Bank of Canada to convert, or "recharacterize," the largely foreign income generated by the portfolio into more desirable return of capital (ROC) and capital gains.

Because foreign dividends don't qualify for the dividend tax credit, the idea here is to make the foreign income more attractive, specifically for non-registered accounts.

Return of capital is generally non-taxable; instead, it is subtracted from the investor's adjusted cost base, ultimately giving rise to a larger capital gain when the units are sold. Capital gains are taxed at half the rate of income.

In 2008, the ETF's first year, distributions were 100 per cent ROC. The proportion of ROC is expected to gradually fall, and the amount of capital gains will slowly rise, over the five-year life of the forward agreement. But ROC should always account for a majority of the distributions, Mr. Seif said.

MY HEAD ISN'T SPINNING ENOUGH YET, MORE DETAILS PLEASE

The mechanics of the forward agreement are complex but they boil down to this: Claymore uses money invested in the ETF to buy a separate portfolio of non-dividend paying Canadian stocks. It then "swaps" the returns of these equities for the returns of the global dividend portfolio, which is in fact held by National Bank.

So the investor is actually getting a return of capital or capital gain from the non-dividend portfolio held by the ETF, but in an amount that equals the income from the global dividend portfolio held by National Bank. That's what allows for the favourable tax treatment of the distributions.

WHAT ARE THE RISKS?

"This is really not a new structure. It's been around for decades," Mr. Seif said. "It's very commonplace and a lot of mutual funds use [the forward agreement structure]."

The derivatives expert I spoke to, who asked to remain anonymous, agreed that the structure is sound. So long as National Bank is solvent and honours its end of the bargain - and there is no reason to expect it won't - the forward agreement needn't scare off investors.

That said, investors need to be mindful of other risks, including the possibility that the value of the stocks in the portfolio will fall, or that distributions will go down.

In fact, the latter has already happened. In early 2008, before the financial meltdown, the ETF was paying distributions of 8.9 cents monthly. But by the summer of 2008, distributions were falling. They dropped all the way to 5.5 cents by September, 2009, and have stayed there. The ETF now yields 4.16 per cent.

The drop in distributions reflected two factors: Some index members slashed their dividends during the recession, and others - some with what appeared to be unsustainably high yields - were kicked out of the index after Zacks' stock-selection methodology flagged them as no longer meeting its criteria. As a result, the amount of cash distributed by the ETF fell sharply.

"For the most part it's a movement away from higher-risk names in the market," Mr. Seif said.

The drop in distributions hasn't hurt the fund's performance, however. The one-year return, including reinvested distributions, is 48.2 per cent, just surpassing the S&P 500's return of 46.3 per cent.

WHAT ABOUT FEES?

Claymore's website lists a management fee of 0.65 per cent, but that's not the whole story. Including costs associated with the forward agreement, the management expense ratio is 0.81 per cent, which is still cheaper than most mutual funds but hardly a screaming bargain by ETF standards.

WHAT ABOUT LIQUIDITY?

The ETF is thinly-traded, with an average daily volume of 14,315 units over the past year. But Claymore employs a market maker, or designated broker, to make sure the bid and ask spreads don't get too wide and still reflect the underlying value of the fund. A spread of 5 to 10 cents is considered acceptable on this ETF, Mr. Seif said.

"I always tell people to look at the bid and ask and make sure that it is reasonable," he said. "If for any reason it's a little wider or different than they expect, they should check with Claymore and we'll always confirm if it's right or not."

THE VERDICT

For investors who want to diversify with a tax-efficient global dividend fund, this ETF is worth considering. But be mindful of its limited track record, market and company risks, the volatile distribution history and the fees. Remember to do your own due diligence before investing in anything.

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Top holdings

Claymore Global Monthly Advantaged Dividend ETF

Top 10 holdings as of Jan. 15.

Holding %
Penn West Energy Trust2.50
Enerplus Resources Fund1.68
Grupo Aeroportuario Del S1.26
CPFL Energia SA-ADR1.06
Grupo Aeroportuario Del Pacifico0.94
Ladbrokes PLC0.91
Bancolombia SA0.88
Chunghwa Telecom-ADR0.87
Yanzhou Coal Mining0.86
BT Group PLC0.80
Source: Claymore

© 2007 The Globe and Mail. All rights reserved.

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