Last fall, Horizons Exchange Traded Funds launched two innovative new ETFs. Rather than simply holding the stocks in the indexes they track, these funds use a derivative called a “swap” to get exposure to the market.
While swap-based ETFs are new to Canada, they’ve been popular in Europe for years. In fact, providers such as Lyxor and db x-trackers, which together offer a couple of hundred funds, use the structure for almost all of their products. Even iShares now uses swap-based ETFs in Europe, though not in North America.
I’ve always appreciated the simplicity and transparency of traditional index funds, and swap-based ETFs don’t fit that description. But they do have the potential to offer significant advantages, especially to investors who have maxed out their RRSPs and other tax-sheltered accounts. Let’s pop the hood on these pioneering ETFs and see how they work.
I’ll show you mine if you show me yours
The first swap-based ETF to hit the Canadian market was the Horizons S&P/TSX 60 Index ETF (HXT). Like the iShares S&P/TSX 60 Index Fund (XIU), this fund tracks a popular index of the 60 largest public companies in Canada. But while XIU does so by simply holding all 60 stocks, HXT gets its exposure indirectly.
If you invest $1,000 in HXT, Horizons places your money in a cash account that earns the prevailing short-term interest rate. Horizons then enters into a total return swap with another financial institution—in this case, National Bank. This “counterparty” agrees to accept the interest on the cash account in exchange for delivering the return of the S&P/TSX 60 Total Return Index. (This includes not only the price change of the stocks, but also all of the dividends.) The upshot is that even though you do not actually own any of the stocks in the index, you have exactly the same market exposure as someone who does.
The one important difference is that HXT investors do not receive cash dividends—in fact, the ETF pays no distributions at all. All the dividends are assumed to be reinvested as soon as they are paid out.
What’s the point?
Why would an investor buy a complicated ETF like this when they could simply use a plain vanilla index fund? The answer is that the swap structure provides two important benefits:
Low tracking error. While most well managed index funds follow their benchmarks closely, it’s not unusual for tracking errors to be a drag on returns. This is especially likely to happen when companies move in and out of the index, which may force the manager to make trades at inopportune times.
With a swap structure, this problem is eliminated. The counterparty must deliver the total return of the index precisely, and if they don’t track the index well on their end, they are on the hook for the difference. For example, if the S&P/TSX 60 enjoys an 8% price appreciation and pays a 2% dividend, then National Bank must deliver a 10% return to Horizons. Investors, in turn, get that full 10% minus only the fund’s management fee and the Harmonized Sales Tax, which adds up to a minuscule 0.08%.
Note that HXT is unique in that it does not pay a swap fee to its counterparty. Its sister fund, the Horizons S&P 500 Index (C$ Hedged) ETF (HXS)—which uses a swap to track the S&P 500 index of US stocks—carries an additional expense of 0.30% for the swap, in addition to its 0.15% MER. Toss in the HST and investors can expect a tracking error of 0.47%—no more, no less.
Tax efficiency. The real benefit of swap-based ETFs comes when they are held in taxable accounts. Unitholders of HXT and HXS receive the full value of any dividends paid by the companies in their indexes. However, because they receive no distributions, those dividends are not taxable.
This is fundamentally different from a simple dividend reinvestment plan. Although DRIP investors collect their dividends in the form of new shares, they still get a T3 slip every year and must pay tax as though they received them in cash. With a swap-based ETF, however, no tax is payable on the dividends as long as the investor holds the fund.
Assuming a 2% yield and a dividend tax rate of 25%, that adds up to a savings of 50 basis points per year for HXT investors. The savings would be even greater with HXS, because foreign dividends are fully taxed as income. Assuming a 2% yield and a marginal tax rate of 45%, the net benefit is 90 basis points.
It’s important to understand that the dividend portion of the returns compounds inside the ETF, and when you sell your units, you will pay capital gains taxes. That means your taxes are deferred, not avoided entirely. However, capital gains are usually taxed at a lower rate than dividends, and they are taxed at just half the rate of regular income. So investors are likely to enjoy a significant tax benefit with HXT and HXS over their entire holding period.
What else do I need to know?
While swap-based ETFs have some advantages over traditional index funds, they are not without risks. Later this week I’ll post a recent interview I did with Jaime Purvis, Executive Vice-President, National Accounts, for Horizons ETFs. He’ll discuss both the benefits and the risks of these innovative products and help you decide whether they’re right for your portfolio.
{ 21 comments… read them below or add one }
If we imagine a world where the bulk of money invested in indexes is in swap-based ETFs, we see an interesting incentive. The financial institution backing the swap has an incentive to collude with those who control the constituents of the index to try to create lower returns. If some aspect of the index could be gamed to reduce yearly returns by only 0.5%, the added profits for the swap backer are huge. I have no reason to believe that anything like this is going on presently, but the growth of swap-backed ETFs creates this incentive.
Thanks Dan, looking forward to the rest of the discussion. I’ve not used swap-based ETFs before. Since the bulk of my savings are in RRSP and TFSA, I’m not sure the tax advantages of the swap-based ETFs like HXT would be realized. But if and when I start to build up savings in a non-registered account, I will really need to consider tax implications more closely.
@Michael: I’m not sure I understand. The counterparty’s position should be market-neutral. It is obligated to deliver the returns of the index, so to hedge that obligation, it will (presumably) just buy the stocks in that index. Whether the returns of the index are high or low should make no difference to them. Either way, they collect the interest on the cash account, which is a risk-free return, albeit a small one. I’m not sure why they would benefit from lower index returns.
@DM: There is definitely much less benefit to using swap-based ETFs in tax-sheltered accounts. You could make the argument that HXT’s tracking error will likely be lower than XIU’s, and it may be convenient to have dividends reinvested immediately. But these advantages are pretty small.
How to take advantage of artificially lowered index returns would depend on how the returns are lowered. If future changes to the constituents of the index is done in a way to deliberately insert weaker companies, then the counterparty could benefit by not being exactly market neutral. If the lowered index returns are achieved through accounting trickery, then the counterparty can gain by collecting the gap between real returns and reported returns. The calculations involved in adjusting an index for changes in its constituent companies are an opportunity to use math to artificially lower returns somewhat. Inventive people can look for other opportunities.
I don’t want to overstate any of this, though. From what I can tell, the current handling of indexes appears to be well-managed and transparent. I don’t know how difficult it would be to game this process. My observation is that if enough billions are involved, the counterparties will have a strong incentive to look for ways to game the reported index returns.
For a senior suffering the OAS clawback.
The gains from the HST & HXS are tax as capital gains (50%). would off set some of he pain.
@Gilbert: More importantly, unlike with dividends, you would be able to control when you take those gains. You would not be forced to take taxable dividends that might nudge you over the clawback threshold in any given year. They can remain unrealized gains until you actually need the income.
This is off topic but the globe has some good news for Canadian couch potatoes:
http://www.theglobeandmail.com/globe-investor/funds-and-etfs/etfs/mutual-fund-giant-vanguard-poised-to-set-up-shop-in-canada/article2048413/
Terrific post, thanks.
Another advantage of this type of ETF is that you don’t pay yearly commissions to reinvest dividends… someone who’s hoping to set up a decent account and then try to just forget it (rebalance once a year) with minimal trading will benefit from having one less transaction to reinvest the distributions XIU gives, plus having those sums always in the market (rather than wait 4 to 12 months to reinvest cash sitting idly)
Perhaps I’m just paranoid but this seems too good to be true. Can someone explain NBC’s motivation for taking the other side of this swap?
IIRC from when these products were first introduced the swap agreement is for 5 years. What happens if at that point NBC no longer wishes to partake in this “free” swap on HXT.
Not getting any distributions forever sounds terrific since the vast majority of my investments are unsheltered and I have no intention to ever sell them. However I’m afraid trying to avoid the smallish dividend tax consequences could lead to a much larger bad outcome(full capital gains) if this product’s promoter fails to find suitable counterparties or starts having to incentivize the swaps, leading to non competitive MERs. I have zero interest in Horizon’s other products, not a fan at all of their exotic, overpriced offerings which cater more to traders than longterm investors. It seems to me buying these 2 swap based ETFs means putting your faith in Horizon for a very long time since getting out would have disasterous tax consequences.
The Globe had an artcile (link below) that raises some concerns in recent reports on this type of ETF. The article is written by a columnist who is in the active fund management business so he may be biased but he raises an interesting point.
In particular in the 45 per cent of european ETFs are “synthetic” and have strayed from the “plain-vanilla ETF” strategy that many couch potatoes would strive for. The article claims an independant report which is balanced in its commentary sounds an early warning to regulators and market participants about potential areas of concern – illiquidity, counterparty risk, poor disclosure and misaligned incentives”
http://www.theglobeandmail.com/globe-investor/investment-ideas/features/the-buy-side/cracks-appear-in-the-etf-halo/article2020256/
It does seem like the couch potatoe strategy simplified the whole Mutual Fund mystery of hidden fees etc. and now some banks are out to to get another fraction of a percent by complicating it once again….For now I will stick the the more transparent approach.
@gsp: I’ll be getting into some of this later in the week. But the short answer is that the banks seem to have identified some kind of arbitrage opportunity that allows them to deliver the return of the index and still have a little bit left over for themselves.
Thanks for the discussion on this topic.
How will this type of ETF structure affect bid/ask spreads? With “plain vanilla” ETF’s the NAV can be easily calculated, and big market makers can create or collapse ETF units to arbitrage any discrepancy between NAV and ETF price. This keeps bid/ask spreads very tight for widely traded funds such as XIU. But with the swap structure, the value of reinvested dividends etc. is less transparent. If this leads to less opportunity for intra-day arbitrage, could bid/ask spreads (and therefore trading costs) rise for individual investors?
I agree with gsp’s comment that investing in this sort of ETF requires putting much faith in the survival of Horizon and their agreements with their counterparties.
I just read horizons summary for HXS (S&P 500), and it says that it also shelters the client from US withholding taxes…
“With a management fee of 15 basis points plus applicable taxes, HXS is a low-cost Canadian ETF that tracks the S&P 500® Index, and offers a tax-efficient total return structure which is not subject to U.S. withholding tax.”
So… the question is… Am I dreaming? What is the catch?
Dan, can you provide us with some enlightenment…
I guess the risk is what happens if the other financial institution (in this case National) goes under? And/or what happens if they decide not to extend the contract…
I guess I do not understand also why there are not more of this kind of ETFs around, for example one for International Markets, etc…
CCP: I’d love to understand how HBP make their money on these ETFs – every time I see some kind of a market-based product offered, I remember my father’s advice: always wonder how they (the people selling the investment) are making money, cause you can be sure that in some way, this product is a winner for them, or they wouldn’t sell it.
To answer my own question of what’s in it for NBC, it appears it’s tax arbitrage. As for Paul G’s question on how HBP make their money off this product, it’s possible NBC actually paid them to create this product. Keep in mind NBC is part owner of HBP so investors are left with serious questions about the nature of that relationship and how it will affect them in the future.
Here’s an interesting thread discussing hxt:
http://www.financialwebring.org/forum/viewtopic.php?f=33&t=112514&hilit=hxt
From that thread comes a good blog post from Dan Hallett explaining NBC’s motives and exploring their credit worthiness.
http://thewealthsteward.com/2010/10/a-closer-look-at-betapros-dirt-cheap-etf/
Dan, I hope you don’t mind me piping in here. One minor clarification…HXT was not the first swap-based ETF. I don’t know what the very first was but any fund offering “tax efficient distributions” likely used a swap. So, things like closed end bond funds – i.e. managed by Marret – and bond ETFs like Claymore’s “Advantaged” bond funds all use swaps or forwards.
gsp, thanks for linking to my post. Given the nature of the bank’s indirect compensation in this deal, it’s likely that any bank would take this kind of business. When I dug into this, I sent a note to a friend of mine working at one of the big banks’ derivatives desks and it was confirmed to me then that not only would banks take this business without charging but they just might pay the fund (or the sponsor – not sure which) to attract this business.
Dan – I’ve been spending more time on your blog in recent days and weeks and really like what I’m seeing. Lots of great information for investors. Keep up the excellent work!
@Dan H: Many thanks for stopping by, and for the clarification. I’m going to be writing about Claymore’s Advantaged ETFs soon. The forward agreements they use are different from the swaps used by Horizons, though the end goal (to recharacterize income as capital gains) is similar.
Thanks for your answer to gsp. When I spoke to Horizons, they said the same thing: banks are apparently quite eager to get this business. They have clearly identified some arbitrage opportunity that provides them a nice profit with minimal risk.
This all is very familiar, the exotic derivatives created pre 2006 by all sorts of “investment houses”, many no longer with us or still struggling to survive, were the root caused for the near destruction of the world financial system-look around to see the results. Recovery from this last debacle is still very much a dream and a wish but already more weird “investment” products are being created; razor thin advantages are being touted as a reason to buy-insane. I like my dividends paid up front (remember-”pay yourself first” from Investment 101) to me. Seems we are right back into a repackaged group of CDOs, CDSs, and securitazations. Is AIG funding the insurance on this stuff?
The counterparty has “identified some arbitrage opportunity”? What does this bit of opaque explanation avoidance mean? Horizon does not know how a co-owner in their firm is making this thing work: bull!
Scammy!
Another benefit I can see for HXS would be the ability to hold this in a TFSA since you don’t have to worry about witholding taxes [like you would with other US exposure ETFs]
Here is the URL of the next article that has the interview with Purvis about some possible downside to these products: http://canadiancouchpotato.com/2011/06/08/swap-based-etfs-what-are-the-risks/
Thanks, great information!
National Bank doesn’t care what the return on the index is. They hedge the exposure by buying the underlying stocks (or other hedging techniques) so that they are market neutral. Otherwise they would have huge market risk and it would show up in their VaR (Value at Risk) measurmeent which they report to the regulators and the street.
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