Monday’s post discussed the inner workings of the two swap-based ETFs launched by Horizons in late 2010. Many investors are understandably concerned about the risks involved in these rather complicated funds, which get exposure to equity indexes without actually holding the underlying stocks.

I recently sat down with Jaime Purvis, Executive Vice-President, National Accounts, for Horizons ETFs, and asked him to explain more about how these products work.

Many investors get nervous when they hear the word “derivative.” Are we going to be reading in the next Michael Lewis book about how total return swaps blew up the ETF market?

JP: People think derivative is a dirty word. But a derivative is simply something that derives its price from an underlying asset. Your Michael Lewis reference is fascinating, because The Big Short describes how they parceled up all of these mortgages that people couldn’t afford, and they lumped together the good stuff and the bad stuff in all of these tranches and tiers. But the underlying assets were not very liquid. If you have a bad house in a bad neighborhood, it’s not like you can sell off a couple of rooms. And if the underlying asset is risky or illiquid, then so is the derivative.

However, when you look at something like HXT, which uses a swap on the S&P/TSX 60, you know there is liquidity there. Those stocks are in the index because of their size and their liquidity. So when you have an underlying asset like that, it’s a safe place to use this type of derivative, or swap structure. In fact, in pension plans across Canada, this is the primary method they use to get long-term equity exposure.

In the case of HXT, you are not paying a fee to National Bank, the counterparty. So what’s in it for them?

JP: Let’s say an investor gives us $100. We take that $100 and place it in a cash account that pays, say, 1.3% interest. Then we swap that return to National Bank, and what we get back is the total return of the S&P/TSX 60.

What’s important to understand is that the counterparty is always hedged. Ideally, if they are obligated to deliver to us the returns of the index, then they will hold those stocks in their own account so they are perfectly hedged. Then they’re essentially collecting a fee for doing the business. They’re getting that 1.3% and keeping that as their profit.

You’ve mentioned that banks are actually anxious for this business, so clearly they’ve identified another opportunity here—some kind of dividend tax arbitrage?

JP: That’s our understanding. There has to be some treatment of the dividends that is beneficial to them, or at least more beneficial to them than it would be to a Canadian retail investor.

[Dan Hallett of HighView Financial Group wrote an excellent blog post describing this idea in detail. According to Hallett, the bank “receives dividends which are effectively tax-free because they’re Canadian-source dividends. But the payment under the swap, which includes an amount equal to the dividends, is fully deductible. This tax arbitrage is effectively National Bank’s compensation for structuring the swap and taking on the tracking error risk.”]

How risky are these things?

Let’s talk about the risk of a swap structure. There seems to be a concern that if the counterparty were to default, then investors in HXT would lose everything.

JP: I think some people are confused about the difference between an exchange-traded fund and an exchange-traded note. With an ETN, you are absolutely tied 100% to the balance sheet of the note issuer. But a total return swap is structured so that what’s at risk is not the principal: it is only the gains, and only up to 10%. [Mutual funds in Canada—and that includes ETFs—are required to limit any derivative exposure to 10% of the fund’s assets.]

So let’s say you put $100 into HXT, and the next day the counterparty goes bankrupt. As a unitholder of HXT, you have no exposure to that counterparty, because you haven’t generated any gains, and they have no claim to your $100 investment.

So imagine I have $100 in HXT and this year the index goes up 9%, and now the value of my units is $109. Then the counterparty fails and cannot pay you that 9% return. You’ve still got my $100 in the cash account earning 1.3% interest, so now it’s $101.30. Does that mean all I lose is the other $7.70?

JP: Yes, that is the extent of your risk. And it’s important to note that any time the gains get to 10%, we would need to find an additional counterparty to take the further exposure, or we would need to crystallize some of those gains in order to bring that number down.

In any case, let’s envision a situation where one of Canada’s Big Six banks might default. The likelihood of one bank being in dire financial straits while the other five banks are not is remote—I think we can agree on that. So in any period when the counterparty might be in trouble, you would assume that the other banks would be down, too. In that case, given the role that Canadian banks play in the TSX 60, you could reasonably expect that the index itself would be negative. There would be no gains for the counterparty to deliver.

The worst case scenario, then, would be a single catastrophic bank failure during a robust bull market. And even then, that just applies to the gains that you have made. It has nothing to do with the principal.

Wouldn’t it make sense to have swap agreements with more than one counterparty, to spread the risk around?

JP: Absolutely. We’re in the process of assessing other counterparties now. It will depend on the amount of assets in the fund, and the maturity of the fund. Remember, it’s only been around since last September. We started with one counterparty, and we’ll look to add others.