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Exchange-traded funds (ETFs) have become popular investment vehicles for their ability to provide diversification, liquidity and flexibility. Beyond these benefits, many investors seek income from ETFs, especially in today's higher-yield environment. In this blog post, we will explore the various ways ETFs generate income and take a deeper dive into one ETF income source that is often misunderstood.
Understanding ETF income generation
Let's briefly examine how ETFs generate income for investors:
1. Dividends: Some ETFs invest in dividend-paying stocks. They distribute income generated from these holdings to investors in the form of dividends. Dividend ETFs are often sought by income-oriented investors seeking regular cash flow.
2. Interest: Fixed-income or bond ETFs generate income through interest payments from the underlying holdings. Investors receive periodic interest distributions, making bond ETFs suitable for income-focused strategies.
3. Capital gains: When an ETF sells a holding for a profit, it can distribute capital gains to shareholders. This can occur in ETFs that invest in stocks or other securities with the potential for price appreciation; during regular rebalancing of an index ETF; or when an active ETF’s portfolio manager identifies new investment opportunities and triggers portfolio changes.
4. Return of capital: Some ETFs use a unique mechanism known as "return of capital" to provide investors with income. This is the focus of our post.
A deeper dive
Return of capital has historically been an income distribution mechanism used by some ETFs, particularly those that invest in master limited partnerships (MLPs), real estate investment trusts (REITs) or other specialized income-generating assets. However, ETFs with other types of exposures may generate return of capital, such as covered call ETFs.
Here are some examples of why an ETF might generate return of capital distributions:
Distributions exceed income: In some cases, the income generated by the underlying assets is insufficient to cover the ETF’s distribution requirements, which may include dividends or interest payments. This can often occur with index ETFs that have a low asset base but are growing rapidly. The portfolio manager may choose to “top up” the ETF yield to ensure it aligns with that of the index.
Income from covered call ETFs: In the case of covered call ETFs, premiums received for covered call options are considered capital gains. Capital gains are distributed annually in December and only on a net basis (capital gains minus capital losses). Capital gains distributions also take into account all available income tax deductions and credits, such as the capital gains refund mechanism. So, while a covered call strategy may result in increased “yield”, it is not reflected in the monthly/quarterly distribution of the ETF. It also may or may not be reflected in the annual distribution. This can often explain why covered call ETFs typically pay a substantial amount of total distribution as return of capital.
Tapping into principal: To meet distribution requirements, an ETF may dip into its capital or principal. This portion of the distribution is classified as “return of capital.”
Tax considerations: Return of capital is treated differently for tax purposes. It's not immediately taxable as income; instead, it reduces the investor's cost base. Taxes on this portion are deferred until the investor sells their ETF shares.
Benefits and considerations of return of capital
Benefits:
1. Consistent income: Return of capital can provide investors with a relatively steady income stream, even when the underlying assets may not produce consistent income.
2. Tax efficiency: By deferring taxes on the return of capital portion, investors can potentially reduce their immediate tax liability, enhancing the after-tax yield.
Considerations:
1. Impact on cost base: Over time, the return of capital reduces an investor's cost base. When shares are eventually sold, taxes will be owed on the capital gains realized, potentially increasing the tax liability.
2. Sustainability: Investors should assess the sustainability of return of capital distributions. If an ETF consistently relies on this mechanism to meet distribution targets, it may indicate an unsustainable payout.
Investors seeking yield from their portfolio should consider diversifying their yield strategies across various types of income-generating ETFs. By combining dividend-focused ETFs, interest-paying fixed-income ETFs, capital gains-driven ETFs, and those utilizing return of capital, investors can construct a well-rounded income portfolio.
ETFs offer a multitude of ways to generate income, with return of capital being a unique and potentially tax-efficient mechanism. While this method can provide consistent income, investors should exercise due diligence, considering the long-term sustainability and tax implications of the various sources of income being generated in ETFs.
Commissions, management fees, brokerage fees and expenses all may be associated with Exchange Traded Funds. Please read the prospectus before investing. Exchange Traded Funds are not guaranteed, their values change frequently and past performance may not be repeated.
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