An ETF (Exchange Traded Fund) is a basket of securities built by an ETF issuer to achieve a specific objective. Unlike Mutual Funds, ETFs are traded on exchanges and their prices fluctuate throughout the day, much like stocks.

Unlike stocks, new ETF units can be created or redeemed based on changes in demand. This article explains in detail how ETFs are made and how they trade.

In general terms a passively managed ETF or investment fund will follow a strict set of rules—such as tracking an index—which means it does not require active portfolio changes and just imitates the index holdings. These strategies can capture a segment of the market in a cost-effective way but cannot act quickly to capture specific opportunities as they arise.

In an actively managed ETF portfolio managers make decisions related to the ETF on a daily basis. These can still come with rules, but the managers have more flexibility to capture opportunities as they see fit.

In the case of covered call option ETFs, a passive strategy would write call options at the same level each month. An active covered call option strategy allows portfolio managers to change the level of options the ETF sells.

This means the ETF can potentially generate more income or capture more upside opportunity based on the changing price of call options.

Investments with an ESG (environmental, social, governance) label have become very popular among investors who want their money to match their social values. The rise of ESG has meant that other forms of values-based investing have been labelled as ESG, perhaps incorrectly.

ESG, put simply, is an investment screening process. Securities are selected with consideration to their environmental, social, and governance scores. This creates a basket of securities which are considered to either be ‘doing good’ or not ‘doing bad.’

A clean energy ETF, such as the Harvest Clean Energy ETF, is focused on companies related to the clean or renewable energy industry. Because these companies are considered to be doing good for the environment, these investments could be perceived as ESG. However, clean energy ETFs are considered hybrid or thematic, built to capture a business theme rather than focus on a set of social values.

ETFs don’t have any minimum initial investment requirements beyond the price of a single unit. Some brokerages have minimum requirements to invest with them, and other brokerages allow investors to buy and sell fractional shares, which would be priced lower than a full unit of an ETF. Generally, however, there is no minimum investment amount beyond the price of one unit of an ETF.

Even for investors focused primarily on income, yield alone should not be the sole consideration. Some investments in Canada might offer yields upwards of 20%, but a range of factors go behind that number which investors should be aware of.

While yield is important, investors may want to consider the underlying securities in an investment, as well as the risk-return rating, past performance, and the frequency and means of that investment’s income distribution. Learn more about factors to consider here.

At Harvest ETFs, we generally use the term “tax efficient” to describe the income generated through our active & flexible covered call options strategy. Because premiums earned in the sale of call options is considered a capital gain and not income, the portion of our Equity Income ETFs’ cash distributions earned from call options is taxed at a more favourable rate than fixed income and non-Canadian dividends when those ETFs are held in non-registered accounts. Learn more here.

Harvest Equity Income ETFs are constructed to provide a reasonable and sustainable distribution yield for unitholders. All Harvest Equity Income ETFs have paid a monthly distribution since their inceptions. Sometimes the underlying options market for a sector will become much stronger or weaker, which can result in a positive or negative change in the distribution.

Nevertheless, Harvest Equity Income ETFs are constructed and managed to provide a reasonable and sustainable distribution yield for unitholders on a monthly basis.

Using a covered call strategy to deliver income gives us more freedom to select companies held by our ETFs based on criteria other than dividends. Therefore, if a holding in a particular Harvest Equity Income ETF does not pay a dividend, it does not necessarily mean it is excluded from a portfolio. A dividend requirement in the underlying holdings is not a necessity across all Harvest Equity Income ETFs. There are select holdings that do not pay dividends included in select ETFs because they meet the objectives of opportunity for capital appreciation or diversification.

In HDIF, for example, a portion of the underlying individual stocks currently (ie. the stocks held in all of the underlying ETFs) do not pay dividends. They are predominately held in HTA, given the growth-sector bias within that ETF, however select positions in other ETFs also do not pay dividends.

The income earned in an ETF and the tax implications of owning units of an ETF are subject to different tax impacts and will depend on whether the units are held in a registered account (such as an RRSP, RRIF, or TFSA) or a non-registered account.

Income earned through distributions from an ETF in a non-registered account:

An ETF that qualifies as a mutual fund trust generally earns dividend income, interest income and capital gains.

Dividend income can be in the form of eligible dividends, non-eligible dividends and foreign dividends (which are subject to withholding tax). The tax rules in Canada require a mutual fund trust to distribute out to unitholders the income generated in the ETF to ensure the ETF will not be liable for income taxes on any realized capital gains, dividends and interest and these rules apply to any mutual fund trust whether it is an ETF, Mutual Fund or Closed End Fund. As a result of this distribution mechanism, those who own units of an ETF will receive a distribution that will follow the tax character as determined in the ETF. For example, if the ETF earned capital gains, you as a unitholder will receive a distribution that will be taxed as a capital gain.

When an ETF distributes its income to unitholders the tax effect for unitholders will be as follows:

• 50% of a capital gain will be taxed at an individual’s marginal tax rate
• 100% of any interest income and foreign income will be taxed at the individual’s marginal tax rate
• Eligible dividends are usually eligible for a dividend tax credit.

Tax implications of buying and selling units in a non-registered account:

In addition to income distributed from an ETF, a unitholder may sell their units after the ETF has appreciated in value. In the event that units are sold at a value above cost, the capital gain will be reported in the year of the sale and 50% of the capital gain will be taxed at the individual’s marginal tax rate. There are times over the course of owning the units where the ETF paid a distribution that was characterized as return of capital (ROC). When this occurs the cost base of the units held by the unitholder will be reduced by the amount of ROC paid out by the fund.

For more information regarding tax considerations in the Harvest covered call ETFs see Tax considerations and covered call ETFs.

For the most recent summary of the Harvest ETFs distributions see Harvest ETFs distribution summary.

This article explains some of the differences between tax treatment of the cashflow, versus the cash flow that is generated. 

The section entitled “Can you explain how your tax factors for distributions have been treated as ROC (Return of Capital) and are you just giving me my money back or “grinding” the net asset value?, explains the difference between cashflow and how that is treated as ROC for tax purposes even if the cashflow is generated by option premium. 

Our distributions are not predicated on hot markets. We calculate the distribution in both up and down market scenarios to ensure the sustainability of our distributions. Covered call options can actually generate higher premiums during volatile periods, therefore our strategy is well suited to certain down market scenarios.

Our ETF distributions are currently sustainable – we make ongoing assessments. If the underlying stocks were to cut their dividends or if there was a sustained downtrend in the markets – we would have to reassess, but currently that is not the expectation or case.

We would encourage you to look at the distribution history of our equity income ETFs, which have stayed largely consistent over their histories.

We’ve endeavoured to put a number of pieces on our learning page located here.

That depends on what ETF you’ve purchased, how many units of it, and at what price. The yield percentage on the day you purchased your units should be indicative of the percentage return you will receive in cash income over a 12-month period. To work out how much cash income you will receive each month it is worthwhile to look at the cash distribution for that ETF, announced each month via press release, and multiply that distribution by the number of units you hold of that ETF.

All Harvest ETFs are registered account eligible. They can be held in RRSPs, RRIFs, TFSAs, RESPs and others. Learn more about how these ETFs fit in registered and non-registered accounts.

Because ETF classes trade independently on the TSX, investors are unable to switch from one class to another directly. Different classes of Harvest ETFs can be bought and sold on the TSX via your brokerage or investment advisor.

Harvest Portfolios Group Inc. is an investment fund manager and an ETF Issuer, not a securities dealer, which means that retail investors must use a brokerage or financial advisor to buy and sell Harvest ETFs. Harvest cannot open investment accounts, accept any trading orders or provide investment advice.

Harvest ETFs all trade on the Toronto Stock Exchange, which is an internationally recognized exchange. Our ETFs can be bought or sold on the TSX from any global location that allows international transactions. However, your ability to buy a Harvest ETF from your US investment account will depend on your dealer or facilitator’s ability to access the TSX for trading.

All Harvest Equity Income ETFs are eligible for the Harvest Distribution Reinvestment Program (DRIP). If you hold units of one of those ETFs, you may opt into the DRIP program through your financial advisor or by contacting your brokerage firm, provided your investment dealer supports participation in the Harvest DRIP program. You can see the list of Harvest DRIP eligible ETFs and learn more about the program here.

A notional non-cash distribution is a special annual distribution that may be paid by Harvest ETFs at the end of the tax year which raises the Adjusted Cost Base (ACB) of the units of an ETF held in a non-registered account. There is no impact on the Net Asset Value of the ETF. You can learn more about a notional non-cash distribution here.

Harvest Equity Income ETFs pay their distributions on a monthly basis. Each month Harvest announces the monthly distributions of these ETFs via a press release and on the TSX website. That press release includes the ex-dividend date for each month’s distributions as well as the payment date set for “on or about” a certain date, typically the 9^th day after month end. The funds are available for brokerages to process as of that date and may arrive in a unitholder’s account on a different date.

We post updated equity holdings for all our ETFs on a monthly basis on our website under the Portfolio tab which notes the individual holding and percentage. Full portfolios will be published semi-annually in their respective financial statements.

Currency-hedged Harvest ETFs will substantially hedge all of the value of their portfolios attributable to the Class A Units’ non-Canadian currency exposure back to the Canadian dollar at all times. As it is substantially—but not 100%—hedged at all times, the impact from currency market fluctuations is generally immaterial. You can learn more about currency hedged ETFs here.

Canadian-listed ETFs that trade in US securities can be subject to some currency risk in addition to market risk, meaning the ETF is exposed to movements in the value of a currency as well as movements in the value of the stock held in a portfolio. Certain Harvest ETFs offer Class A units which use currency forwards to hedge their value to the Canadian dollar, limiting currency risk.

Class B units are un-hedged. You can learn more about currency hedged ETFs here.

Class U units trade and pay their distributions in US dollars. This class is useful for investors who want to receive their income in US dollars. You can learn about class U ETF units here.

Risk rating is determined from a range of factors which could influence the future performance of an ETF. Canadian securities regulators tend to use a metric called standard deviation as the core method of rating risk in an ETF. Standard deviation measures how much an ETF’s returns deviate from its mean returns. The ratings are based on 10 years of performance history or, when 10 years of history does not exist, ratings are calculated from the history of the ETF’s reference index as a reasonable proxy. The risk rating of an ETF can be found in its regulatory ETF Facts.

While other risk metrics are used as part of a Canadian ETF’s risk rating, standard deviation generally forms the core of the rating process as it can help indicate the likelihood that returns may deviate from their mean.

The Net Asset Value (NAV) of an ETF is calculated by adding up the value of all the assets an ETF holds, subtracting all liabilities, and dividing that number by the total number of units of that ETF currently outstanding.

A simple example: An ETF holds a portfolio worth $10,000, has liabilities totalling $1,000, and has 1,000 units trading. Its NAV would be calculated as ($10,000-$1,000)/1,000 which equals = $9.00.

Because ETFs trade on open markets, they also have a market price: the price at which ETF units can be bought or sold during trading hours. Sometimes the NAV and Market Price of an ETF can differ slightly during the trading day. When the NAV is calculated at the end of the day, however, the Market Price and NAV are reasonably close. You can see recorded daily NAV and Market (close)  of Harvest ETFs here.

The management fees and operating expenses of an ETF are calculated daily as a liability and subtracted from the value of an ETF’s assets when the Net Asset Value (NAV) is calculated. Therefore the NAV of an ETF incorporates the management fee and operating expenses.