Here’s part two of my interview with Jaime Purvis, Executive Vice-President, National Accounts, for Horizons ETFs. (See part one here.) In this conversation, we talked about some of the reasons why investors might consider swap-based ETFs such as Horizons S&P/TSX 60 Index ETF (HXT) and Horizons S&P 500 Index (C$ Hedged) ETF.
When you launched HXT last September, you went head-to-head with the iShares S&P/TSX 60 Index Fund (XIU), which has almost $11 billion in assets. Why would an investor switch from the largest ETF in Canada to a new product to save nine basis points?
JP: It’s true, XIU has been a landmark product in Canada for more than a decade. So when we looked to launch our product we asked, how can we compete? We didn’t just want to compete on cost, because that is a difficult strategy—although we did say that we would go as low as we could possibly afford to. And with about $300 million in assets, we are comfortable with our profit and loss on this product.
This company has always been about innovation. Whether it was leveraged and inverse ETFs, or actively managed ETFs, we have always looked to innovate and make things better for clients. So we asked what we could do here to improve upon a TSX 60 product. And given that all of the exposure in our leveraged and inverse ETFs is done synthetically, through some sort of derivative or swap, we were very comfortable creating a product like those that have evolved in Europe, using total return swaps.
So when you ask how we can expect people to switch from something that costs 0.17% to something that costs 0.08%, the point is there are two other benefits that come from using a total return swap. The first is perfect tracking of the index. But the major benefit is your treatment of dividends.
When you own a total return index, as soon as the dividend is paid by the company, it is automatically reinvested. You are getting reinvestment from day one, rather than waiting until the end of the quarter, so you’re getting the added compounding. This is not a huge event with distributions of 2% per annum, but these little things all add up. Secondly, there is no tax liability to the holder of HXT until they sell their units, at which point they are capital gains.
Are you aiming these swap-based ETFs specifically at taxable investors? Because for an RRSP investor, the tax benefit is zero.
JP: I would agree. But for taxable accounts, this strategy makes a lot of sense. And I would point out that the benefits are even greater for HXS. Think about how Canadians get treated on foreign dividends: there is a withholding tax on those dividends, although you do get a tax credit for them. Plus you are taxed on them at the same rate as income. So if the yield is 2%, we say that on an after-tax basis HXT could save you 50 basis points a year. Well, HXS can save you 90 basis points.
Given that the swap structure guarantees that Horizons will get the total return of the index, can an investor in HXT fully expect that they will receive the total return of the S&P/TSX 60 minus eight basis points every year?
JP: Yes, they should. We cannot foresee any circumstances where we would have any slippage. Even if the swap counterparty erred on their side of the portfolio, they are still obligated to deliver us that total return.
And you can expect HXS to lag the S&P 500 by 47 basis points—15 basis points for the management fee, two for the taxes, and 30 for the swap fee paid to the counterparty. But those 90 basis points of outperformance on the tax more than make up for that.
Why does HXS charge a swap fee of 30 basis points, while HXT charges no such fee?
JP: Just like Canadian retail investors, Canadian financial institutions don’t get as favourable a treatment on US dividends as they do on Canadian dividends, so that’s why they have to pass on some costs to investors.
{ 6 comments… read them below or add one }
I must say, I thought these swap-based ETFs were pretty scary until I read these posts. Thanks for clarifying a pretty complex financial manoeuver!
Agreed, thanks for clarifying this. If only Horizons did such a good job on their website. I will certainly consider getting HXT for my taxable although I still trust the plain vanilla a lot more.
Thanks for the very informative thread Dan. If I understand this correctly, this is where one should invest if the funds are held in a holding company. Revenues are controlled as capital gains for the amount one chooses to sell.
Sounds like total control over amount of revenue generated. Good stuff!
Thanks again. Keep up the good work.
“But for taxable accounts, this strategy makes a lot of sense. And I would point out that the benefits are even greater for HXS. Think about how Canadians get treated on foreign dividends: there is a withholding tax on those dividends, although you do get a tax credit for them. Plus you are taxed on them at the same rate as income. So if the yield is 2%, we say that on an after-tax basis HXT could save you 50 basis points a year. Well, HXS can save you 90 basis points.”
Could someone explain how he got to those numbers? They seem inflated to me.
@acmz: I’m not a tax expert by any means, but it does sound like these ETFs would be suitable for a corporation that wanted to defer taxes and control when to take profits.
@gsp: These numbers are based on an assumption of a 25% tax on Canadian dividends and a 45% tax on regular income. A 2% dividend taxed at 25% would be a cost of 50 basis points; at 45% the cost is 90 basis points.
Remember, of course, that these tax savings would be enjoyed in the current year, but there will be a tax bill down the road, when the investor sells the ETF and realizes the capital gains. In the case of HXS, there may still be a savings, as capital gains are taxed at half the rate of income.
That’s what I figured, bogus numbers. How can he count the yearly dividend tax savings and completely ignore the increased capital gains liability at disposition? In the lower brackets dividends are taxed at lower rates than cap gains, let’s ignore that too. He mentions the foreign dividend withholding tax credit and then follows up by once again ignoring it in his HXS calculation.
HXS comes with a 40 basis point disadvantage to the better diversified VTI. Hard to see how that can be made up once you factor in the foreign dividend tax credit and higher cap gains upon selling.
Didn’t have a very high opinion of these guys beforehand and such used car salesmen tactics aren’t improving that image.
Another beauty that made my skin crawl: “Whether it was leveraged and inverse ETFs, or actively managed ETFs, we have always looked to innovate and make things better for clients.” Yes, “better” is the term I’d use to describe those products…