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 taxes, 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 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.