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Why I Don’t Use a Dividend ETF for my Leveraged Portfolio

A reader left a comment in my last Smith Manoeuvre/leveraged portfolio update questioning why I don’t simply use CDZ since my holdings are similar.

My leveraged portfolio consists of a basket of Canadian dividend stocks that mostly have a history of raising their dividends.   The Claymore Dividend ETF, CDZ, tracks the Canadian dividend achievers index which holds stocks that have increased their dividend at least once annually over the past five years.

Since my leveraged dividend portfolio and CDZ both have similar strategies, thus holdings, why don’t I simply buy CDZ and reduce all the hassle of buying and selling individual stocks and reducing my commissions paid to the online stock brokerage?  Here are my reasons.

1. Control the Yield

One of the main reasons I started a dividend portfolio is for the tax efficient income with the goal of having the investment income grow enough to pay a significant portion of our household expenses.  With that goal in mind, it’s important to have a relatively high sustainable yield that grows with inflation.

If I were to choose the CDZ or XDV (iShares) ETFs, I would not have control over the yield of my portfolio because those ETFs weight their portfolios (thus yield) based on the market capitalization of the company. For my portfolio, I have a watch list of stocks that I like, then wait until yield reaches a level that I’m happy with (ie. when the stock becomes cheap).  Here is a tutorial of when to buy dividend stocks.

2. Return Of Capital (ROC)

Oh the dreaded ROC.  With leveraged portfolios, receiving Return of Capital as a portion (or all) of a distribution can have implications on tax deductibility of the investment loan. ROC is typically distributed by income trusts, which CDZ still holds a couple.  There are ways around this, namely withdrawing ROC, paying down the investment loan, then putting the money back into the trading account.  However, that is too much hassle for me.

In addition to that, ROC reduces the adjusted cost base of the stock position which needs to be tracked manually for the capital gains calculation when the position is sold in the future.

3. Management Expense Ratio (MER)

Finally, CDZ has a relatively high MER coming in at 0.60% per year.  While some may argue that I have pay trading commissions, the strategy is to buy and hold most positions forever, which means trading commissions occur with a relatively low frequency.  To put this in perspective, a $100k portfolio paying 0.60% is $600 per year, every year.  With $4.95 commissions and infrequent trading, the expense ratio of my leveraged portfolio will be a fraction of the ETF.

What are your thoughts?  Do you use leverage for your stock holdings?  Do you use ETFs?

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 39 comments… add one }
  • Sustainable PF January 9, 2012, 10:30 am

    While I knew all of this via piecing together information from your other articles (and the comments) thanks for consolidating the points into one article FT!

  • Andrew F January 9, 2012, 11:23 am

    I largely see your point. I’m not sure I agree about ROC. Avoiding it makes the record-keeping easier. I don’t see why you should need to withdraw the ROCs and reinvest them… reinvesting the ROC should be sufficient.

  • Steve January 9, 2012, 11:27 am

    I think it comes down to how much control you want. If you really don’t want to have to deal with monitoring the performance of your holdings and making adjustments and buying decisions, then use the ETF. That’s exactly what ETFs and the MER are there for.

    But if you’re someone who enjoys tracking, monitoring and analyzing holdings and potential purchases, and you are a mid to long term investor, then the ETF product really isn’t right for you anyway.

    I think we know which category FT and most of his readers fall under.

  • On Demand January 9, 2012, 4:11 pm

    Do you consider the price different comparing to the NAV when trading ETF’s?
    Currently, CDZ is trading at the premium while XDV is trading at discount. Does it made XDV a better ETF to buy now? btw. XDV yield @4% and CDZ @3%.

  • Mike January 9, 2012, 5:19 pm

    I would like some clarifications on this post. Specifically two points;

    1- Yes or no, do I really to be withdrawing ROC, and paying down the investment loan? And Why? Can we separate the NICE to do, versus the MUST be done in order to comply with CRA rules.

    2- Also, how could Return of Capital as a portion (or all) of a distribution can have implications on tax deductibility of the investment loan?

    I am looking to achieve the Smith Manoeuvre using the CDZ or XDV ETF’s. It would be great to have a dedicated post to this approach for the investors who, like me, who do not have the time or expertise to stock pick.

    Thanks!

  • The Passive Income Earner January 9, 2012, 6:09 pm

    I also prefer to control the dividend yield and would do the same. The reason is that a select number of companies actually increase their dividends annually which is even better than the dividend achiever in the ETF. Over time, the dividend growth actually makes a positive impact on your return.

  • Rob January 9, 2012, 6:42 pm

    I would like some clarifications on this post. Specifically two points;

    1- Yes or no, do I really to be withdrawing ROC, and paying down the investment loan? And Why? Can we separate the NICE to do, versus the MUST be done in order to comply with CRA rules.

    2- Also, how could Return of Capital as a portion (or all) of a distribution can have implications on tax deductibility of the investment loan?

    I am looking to achieve the Smith Manoeuvre using the CDZ or XDV ETF’s. It would be great to have a dedicated post to this approach for the investors who, like me, who do not have the time or expertise to stock pick.

    Thanks!

  • Jungle January 9, 2012, 9:21 pm

    Ed Rampel says just to reinvest the distributions or pay down the loan and you will be fine.

    We reinvest all dividends when possible anyway.

    Hey Frugal have you rethought about paying off your investment loan? I don’t think you really need it anymore?

    If we move to the house I want this summer, we will have only about $60K mortgage left. We can pay this off fast. All the rest of our debt will be tax deductible.

    With a paid off mortgage and strong cash flow, do you really need an investment loan? How do you determing when to pay it off?

  • Eve January 9, 2012, 9:34 pm

    If there are areas where you don’t have the expertise to select stock then they would be fine. Personally I have one CHB a high yield bond fund. Yield of 7.7%. I do not purchase any bonds separately. Also high yield usually means higher risk so for me it makes sense to use a fund which is diversified. I realize that interest income is not taxed as favourably as dividends

  • Joe S January 9, 2012, 9:34 pm

    CDZ’s distributions have been cut since inception. From 7 cents to 5.5. I would conject that is because they had many income trusts that had to cut their distributions with the introduction of the new tax. Still, with rebalancing and companies coming on and off the dividend achievers list, you have zero control of buying and selling. For example, they sold all of the Canadian banks the year after they did not raise their dividend and took big losses, and they never ended up cutting the dividend and now they’re quite far ahead.

    What I like about CDZ and XDV is they provide a nice screen of companies to look at and buy directly. I own many on both lists.

  • My Own Advisor January 9, 2012, 9:38 pm

    I agree with everything above.

    Mainly, why pay MERs when/if you don’t have to?

  • My Own Advisor January 9, 2012, 9:40 pm

    @Joe S.

    I do the same. I use dividend ETFs as a great screen for stock selection. I figure if it’s good enough for a $1 billion-dollar ETF to hold this company, it is good enough for me.

  • Brad Ferris January 9, 2012, 10:34 pm

    Great post MDJ. I’ve never really been a fan of the dividend ETF universe. Simply I’d rather hold the individual quality companies than a collection of the good & the bad. They’re also more riskier, as you pointed out, when you’re using a leveraged strategy

  • FT FrugalTrader January 9, 2012, 11:11 pm

    For those of you confused by ROC, it is confusing! Please read the following posts for more clarity:

    http://www.milliondollarjourney.com/how-return-of-capital-works.htm

    http://www.milliondollarjourney.com/key-tax-considerations-on-an-investment-loan.htm

    The issue is simply when you withdraw from the leveraged portfolio. Dividends and interest are ok, but capital gains/ROC are a bit trickier. If you have a mix of all in the portfolio, how does CRA determine which is which? Best to consult with an accountant, but if you want to keep the account really clean, then withdrawing the ROC to pay down the investment loan seems like a good idea.

  • FT FrugalTrader January 9, 2012, 11:21 pm

    @Jungle, i’m going to keep the investment loan for now. I capitalize the interest so that the payments do not eat into my cash flow, and since i’m in a higher tax bracket, the tax deduction works out well.

  • Howard Hare January 10, 2012, 10:38 am

    I like CDZ, simple and lowers risk parameters.

    I also own JNK for cash flow, and the new ZWB and’or LXF should also be a small % to juice yields.

    I look on these like owning an apartmnet building, i don’t care about what the building is worth today as long as the Rent Cheques keep coming.

  • My University Money January 11, 2012, 12:28 am

    Thanks for putting this all together FT. Much like Sustainable PF above, I knew most of this from your other posts, but as someone about to start the SM, this makes a lot of sense!

  • Winn @ Stock Income Method January 11, 2012, 3:11 am

    Great Post! personally I don’t use leverage on my long term holding because using margin on investment you need to pay interest rate on it. Interest rate range any where from 5-10% depend on which broker you use. There are many alternatives to increase you holding without using any margin. For instance, you can use deep ITM LEAP Call option to increase your holding for a fraction of the cost and lower your overall risk.

  • Mike January 16, 2012, 8:34 pm

    Great post in general! One thing that I have found over my own personal experiences is that most Accountants (referring to the RoC point and other fine tax details not available on blogs) are not aware of the Smith Manoeuvre, hence are incapable of giving proper advice…

    If someone knows one in Toronto that’s really savvy on the topic, please don’t hesitate to share his coordinates.

    Anyone else had the same experience?

  • Andrew F January 16, 2012, 8:53 pm

    Mike, try Ed Rempel. He’s written on MillionDollarJourney about SM several times and I believe he is based in the GTA. He seems to know what he is talking about on the subject, though I don’t agree with his philosophy about being able to select active fund managers that will outperform the market.

    http://www.edrempel.com/

  • Brendan March 12, 2012, 6:00 pm

    Frugal, has CRA questioned your capitalizing the interest?

    I have read IT 535, or whatever one deals with interest expense.

    I still have a hard time believing you can simply reborrow from the credit line to pay interest, and CRA allowing compound interest to be deductible.

    I ran the SM past an accountant and he suggested to buy dividend stocks, and use the dividends, or my own money to service the LOC.

    Currently I could have a portfolio that covers the interest, and still have a bit left over to pay down my mortgage.

    Eventually with dividend growth I would be cash positive more and more each year, not to mention the capital,growth that usually accompanies dividend growth.

  • FT FrugalTrader March 12, 2012, 7:56 pm

    @Brendan, why would they question it? Providing that the investment line of credit is kept separate from personal expenses with a clear paper trail, it is within tax law.

  • Brendan March 12, 2012, 8:34 pm

    As with all CRA literature, words like “should, may, could” are used.

    I couldn’t even get a straight answer on the phone from CRA.

    Does your bank simply add the interest costs each month to your LOC, or do you transfer the amount of interest to a chequeing account, and then “pay” the interest cost?

    Just wondering how you have it set up, and if your were ever audited, and if so how did it go?

  • FT FrugalTrader January 6, 2013, 8:27 am

    @Brendan, just seeing this comment. I have it setup so the LOC gets paid by a chequing account automatically to cover the interest. The chequing account is not used personally with the only purpose of paying the investment loan LOC. I use a very good accountant to file my taxes (personal and business), and he has no issues with my setup.

  • CP January 11, 2013, 11:33 am

    Also Dividend Achievers index didn’t do too well last year. It had big loser such as Reitman’s and CNQ. Both of which I would not have invested in. So I prefer to use the dividend achievers index to give me a starting point on some stocks, but then add in my own analysis.

    • FT FrugalTrader January 11, 2013, 5:00 pm

      For 2012 CDZ did a little over 9%, which was much better than the TSX return of about 5.5%.

  • Freeagent January 22, 2013, 4:12 pm

    XDV has included 10-18% ROC in it’s distribution since 2007. Yet it’s mandate is to only include dividend paying stocks, so no REITs or other distributors of ROC.

    Can anyone explain where the ROC comes from? It no doubt affects the taxation of the distributions.

  • Phil B February 5, 2014, 10:46 pm

    That still hold true today with the new dividend ETF like XDV, VDY, ZDV?

  • Brandon April 2, 2014, 7:53 am

    How can you tell is a stock or ETF gives you return of capital?

    Thanks!

  • FrugalTrader April 2, 2014, 10:05 am

    @Brandon, best bet is to visit the ETF’s website and click on the “distributions” tab, it will outline the tax breakdown of the distribution.

    http://ca.ishares.com/product_info/fund/distributions/XIU.htm

  • Brandon June 13, 2014, 3:00 pm

    Thanks FT!

    Also could you give me your opinion on this idea for the smith maneouvre. Would you reccomend using an index ETF with a Low MER of 0.1% and dividend around 2.5% or a dividend index ETF with a MER around 0.5% and a dividend around 4%. I understand with the SM its good to receive dividends as you can roll them back onto the mortgage and convert more bad debt into good debt but is it worth the higher MER?

    Another thing that im not sure about is if I have no exact way to be sure of the ROC until year end with an ETF would it be safe to say that I take a look at the distributions over the past five years and go above the highest ROC % and pay down the LOC and then reinvest and use the rest of the distributions to paydown my mortgage? Will my investment should still stay tax deductable correct?

    Look forward to hearing you response!

    Thanks!

  • Brandon June 13, 2014, 6:43 pm

    Also if I just set up a DRIP with my ETF through my brokerage would my investment still be 100% tax deductable?

    Thanks!

  • Le Barbu October 20, 2014, 12:07 pm

    I would not set DRIP because it’s more difficult to calculate buying cost afterward. You better control every purchase with a date a purchase cost.

  • Joe July 8, 2015, 4:34 pm

    Hey Frugal,

    It’s been a few years since the last comment. What would your opinion be on ZDV with a lower MER (0.35) and commission free etc purchases with Questrade for the SM.

    Fantastic blog btw.
    Joe

    • FT FrugalTrader July 10, 2015, 8:45 am

      Hi Joe,
      The same issue with ZDV where it pays ROC (http://www.etfs.bmo.com/bmo-etfs/distribution?fundId=86809). However, it is possible to own it if you track it and keep all distributions within your investment account.

      • Mike July 10, 2015, 4:00 pm

        The iShares XDV etf is interesting. Looks like it’s all Canadian pure dividends (no RoC or interest) and only 0.55 MER. Frugal: would that work for the SM?

      • Joe July 10, 2015, 4:26 pm

        Thanks for the quick response Frugal. I’m interested to hear what your opinion/answer is to Mike’s question?

        Thanks again
        Joe

        • FT FrugalTrader July 10, 2015, 8:46 pm

          They must have recently changed XDV. In the past, they paid ROC. It appears that they do not pay ROC right now, or at least I can’t find the information. If they do not pay ROC, I would be fine with using XDV with SM. However, that’s not to say that they won’t pay ROC in the future.

          Remember though guys, if you use leveraged SM for Canadian dividend stocks, you want to make sure to get global diversification in your other accounts (RRSP, TFSA etc).

          • Joe July 12, 2015, 8:08 am

            Thanks for the reply Frugal.
            Take care
            Joe

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