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Are You Holding Total Return Funds?

Total return ETFs offer tax advantages over normal dividend products. If you don't need the income, a total return ETF may offer an attractive option for your portfolio.

Total return ETFs enable investors to maximize capital gains over dividends. Essentially they operate like a DRIP would, but don't require any setup.

Dividends Are Important

Not everyone has to be a dividend investor to appreciate dividend-paying companies. After all, dividends are a strong signal from management that the company is performing well and they can payout extra profits back to shareholders.

The big-5 Canadian banks are the bellwethers in this space - having never cut dividends in their collective history. This has made them known globally for their prudent management despite economic downturns.

So while you may not care about receiving a quarterly cheque in the mail, a consistent dividend history is a strong signal of a company's strength.

Becoming A Dividend Investor Without The Tax Consequences

One of the main aversions for non-dividend focused investors is the tax consequences that come with receiving them. Dividends are treated as taxable income, with preferential treatment for Eligible Dividends paid out by Canadian companies.

Enter Total Return ETFs. Unlike a traditional equity ETF which owns the underlying portfolio directly, a total return fund is a synthetic product that utilizes swaps to mirror the index indirectly. Because of this structure, dividends are automatically reflected in the NAV of the fund, increasing its value rather than paying out a distribution.

This means that you can gain access to a blue-chip dividend portfolio without paying the tax (until you sell).

Avoiding Foreign Withholding Tax

Another important consideration is foreign taxation on your international holdings. Foreign governments apply a withholding tax on Canadian investors owning their securities, like the US levying a 15% tax that gets deducted off your distributions automatically.

By employing a Total Return ETF, you avoid this extra bill since no dividends are actually collected by the fund.

Additional Risk Factors

It's not without risk, however. Because these ETFs utilize swaps - a derivative instrument, additional risk factors like counterparty risk enter the equation. Tracking errors with the underlying index can also increase, albeit still remain marginal.

Popular Total Return ETFs

Horizons has a whole suite of total return products you can peruse here. These include the TSX 60, Canadian Banks and S&P 500. Their TSX60 and S&P 500 manage over $2bn in assets while maintaining below 1% tracking errors despite using derivative instruments, and despite the volatility we witnessed in the equities market in 2020.

Concluding Thoughts

If you do not need the income, a total return strategy optimizes your portfolio's tax efficiency by transferring taxable income to deferred capital gains. While synthetic ETFs introduce new risk factors for your portfolio, the long-term track record of Horizons' products remains consistent, and has been able to weather volatile markets.

At Investipal, we assess the tax consequences of the specific account you are investing with and score your ETF universe accordingly. For example, if you are using a non-registered account, we score total return ETFs higher to account for the preferential tax treatment these products offer.

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