Your Complete Guide to Index Investing with Dan Bortolotti

More Swap Talk With Horizons

2018-06-17T21:03:31+00:00June 10th, 2011|Categories: ETFs and Funds|Tags: , , |17 Comments

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 (HXT) and Horizons S&P 500 ETF (HXS).

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.



  1. Patrick June 10, 2011 at 10:19 pm

    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!

  2. orange June 11, 2011 at 12:14 am

    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.

  3. acmz June 11, 2011 at 4:48 pm

    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.

  4. gsp June 12, 2011 at 8:09 am

    “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.

  5. Canadian Couch Potato June 12, 2011 at 9:06 am

    @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.

  6. gsp June 12, 2011 at 10:00 am

    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…

  7. Oldie July 9, 2012 at 6:32 pm


    Disclosure: I am a rank beginner at all this, and am slowly learning all I can. I only just learned what a Total Return Swap was a couple of weeks ago. That being said, it seems to me that your comment made a year ago, if you’re still logging on, “That’s what I figured, bogus numbers.” is unfounded.

    For HXS, the “yearly dividend tax savings” has to be examined in the context that dividend from US sources does not qualify for the same preferential tax treatment that Canadian dividend does (I am assuming we are talking about a fully taxable portfolio, an RRSP not being an efficient vehicle for HXS, as CCP has pointed out) and would be taxed fully at the investor’s marginal tax rate. This tax would not be trifling for a large non-RRSP, non TFSA portfolio. By not having any dividend at all, there will never be any 15% withholding of any dividend at source (but I guess this does not enter into the better/worse equation because if you were charged withholding tax you could apply for a credit) nor income tax burden in the year(s) of dividend/income. I don’t believe CCP ignored the capital gains tax to be paid eventually at disposition — he did account for it, but made the valid point that a dollar profit taxed as a capital gain is cheaper than a dollar profit taxed fully as income at any marginal rate (except where the rate is zero, which seems unlikely).

    It’s an arcane field, and I’m stumbling through the numbers myself. But to criticize CCP for fudging the numbers mystifies me. Assuming the facts are correct, the numbers seem to pan out (except for an arbitrary 2% dividend estimate — do you disagree with that?). This could work for me, assuming I will be at the higher marginal rate when the dividends/gains would occur (IF they do haha.)

    I don’t like the high MER of 0.45%
    I don’t like the hedging of the US currency.

    But I don’t need the income in a proposed taxable portfolio, so I could postpone realization of capital gains/profits for as long as I need to, apart from minor annual rebalancing; if investing in the conventional alternative, the tax paid on dividends from US Equity conventional ETF’s could be onerous. The 0.45% MER seems cheap in comparison.

    The tax comparisons above apply only to HXS in a taxable portfolio. HXT (I don’t know if you also had an issue with the numbers here) generates a whole different calculation comparing preferential Canadian dividend tax treatment in the year of dividend payment versus deferred Capital Gains Taxation years down the road after, hopefully, compounding of gains. But it might still work for some investor situations.

    I take your point that you always have to watch your own wallet in the presence of salesmen, but I would appreciate a critique of my numbers, if you’re still available. @CCP, too, if I have made any errors or misrepresentation, correction would be appreciated.

  8. Canadian Couch Potato July 9, 2012 at 6:50 pm

    @Oldie: Your assumptions are correct, and gsp was wrong in his assessment of HXS. As you point out, foreign dividends are taxed at twice the rate of capital gains, so there is the potential for significant tax savings, not just tax deferral.

    The tax advantage is much smaller with HXT because of the dividend tax credit, but there is still potential value in deferring all taxes until the fund is ultimately sold rather than paying taxes on the dividends every year.

    The foreign withholding tax is actually a bit of a distraction. If you were to buy a US-listed ETF that tracked the S&P 500, you would pay withholding tax in a non-registered account, but this is usually recoverable by applying for the foreign tax credit on your return. So HXS provides no advantage or disadvantage in this respect.

  9. rn November 30, 2012 at 11:25 pm

    Even though for many the withholding tax is not really a big deal, for some investors (e.g. a spouse with no regular income) it can make a real difference, making HXS that much more attractive.

  10. gsp March 16, 2013 at 4:58 pm

    Wowser, in revisiting this post I see some comments were made in my direction well after the fact.

    Oldie, might I suggest you read my comments again and tell me where I ever criticized CCP or his numbers? I was commenting on Mr. Purvis willfully ignoring the added cap gains taxes in his 90 basis point calculation. Add in 2% at 22.5% cap gain tax rate and the advantage is down to 45 points. Account for the cost difference vs VOO and it’s down to under 5 basis points(VOO always seems to have lower tracking error than its MER).

    For this you take on counterparty risk and hope the fund will stay open for your holding period(Horizons close funds every few months it seems) and that no adverse tax change will affect your holding. The advantage is in the tax deferral, not some bogus .9% tax advantage. To easily see this, assume the investor liquidates an amount equal to that year’s dividend. Any advantage disappears.

    What’s more with the benefit of hindsight we can see that while VOO’s tracking error has been exactly 2 basis points the last 2 years. HXS has lagged by 82 and 29 points and it is judged against the inferior hedged index.

    In rereading my post above 2 years later I’m not sure what I was talking about in the last sentence of my first paragraph(RE: div tax credit), my bad.

    Starting April 1st, HXS will drop the hedging and track the same index as VOO. Horizons will also be offering units in USD.

  11. George December 13, 2016 at 8:41 pm


    I’ve become a big fan of Horizons’ etfs in taxable accounts to avoid all of the tax issues in taxable accounts, so I own HXT (Canadian equity), HXS (US equity), and HBB (Canadian bonds) in a taxable account. These etfs are tax efficient, swap-based etfs using forward contracts that are not supposed to pay distributions each year.

    I own ZEA for my international equity exposure in this taxable account, which pays distributions and capital gains. Horizons just came out with a Eurozone-focused ETF, HXX, which tracks the EURO STOXX 50 that is tax efficient structure like HXT, HXS, and HBB.

    I was thinking of replacing ZEA with the new HXX. I’d lose diversification, as major companies in UK, Japan, Australia, would not be included, but gain in tax efficiency. HXX has major global companies in the Eurozone. Any views on making this switch?

  12. Canadian Couch Potato December 14, 2016 at 7:17 am

    @George: I don’t have a major issue with swap-based ETFs and think they can be a reasonable choice in taxable accounts. However, they do carry some additional risks, including the possibility that the government may one day put a stop to the swap structure, which could force holders of these ETFs to liquidate them, potentially realizing large capital gains. So I would caution against keeping virtually all of one’s taxable portfolio in swap ETFs. As you’ve pointed out, the Euro ETF is not as broadly diversified as a conventional EAFE index fund, so that means putting tax-efficacy ahead of risk management, which is also problematic.

  13. Gordon February 8, 2018 at 11:26 pm

    CCP – great articles and discussion of the TRS.

    One thing that concerns me, especially in light of this week’s selloff in the market, is the potential for CRA to bring legislation against the tax advantages for TRS. If a TRS ETF were to lose value like this week and CRA were to require a liquidation of these ETFs, the holders would potentially be faced with a capital loss (very bad) instead of a capital gain (not the end of the world).

    Also, for holders of TRS ETFs, is there any way to confirm the value of the distributions that are implied since they are simply rolled into the value of ETF units? It would be nice if this was provided as some kind of a line item for the investment.


  14. Canadian Couch Potato February 9, 2018 at 7:20 am

    @Gordon: Glad you enjoyed these. The danger of the government changing the rules is probably the biggest risk around the TRS structure. But being forced to realize a capital loss is not “very bad.” You could immediately repurchase another ETF tracking the same index and keep your exposure exactly the same. You would not be selling low and buying high: you would be selling and buying at the same price. It’s just forced tax-loss harvesting. Realizing a huge gain during a year when your income is high would be far less desirable.

    To understand what component of the TRS’s gain comes from price appreciation and what comes from “implied dividends,” you could just compare the returns to a traditional ETF tracking the same index. For HXT, for example, you could compare it to XIU, which also tracks the S&P/TSX 60.

  15. Gordon February 9, 2018 at 10:56 am

    Good perspective – thank you.

    Do you have an opinion regarding using the TRS investments as part of a regular income stream? The tax advantages still apply and the distributions are still there only as units. Any thoughts?

  16. Canadian Couch Potato February 9, 2018 at 11:02 am

    @Gordon: I think you have misunderstood something: there are no distributions at all. It’s simply that the units appreciate in price: i.e. a 2% dividend is reflected as a 2% increase in the unit price. So a swap is really the wrong product for investors who need income. I actually just addressed this same question in MoneySense, so this should help:

  17. Gordon February 10, 2018 at 3:01 pm

    Yes, I understood these “distributions” as an increase in unit price. I especially like the tax advantages of the TRS as has been discussed in the various comments for these articles. So, any distributions will increase the unit price accordingly. It seems to me then that generating income from a TRS will work particularly in a rising stock market where the unit price increases along with the market. If there is a decrease in the market, selling units without decreasing your original investment in the TRS will be an effort. However, to the extent that one can limit the units sold such that the original investment is retained (which is really just keeping track of the amounts originally invested), generating income with a TRS should be do-able. Again, the whole point of this is to take advantage of the favourable tax treatment with the TRS. I have more assets in my non-registered accounts than registered.

    I’m not looking for a return of capital. My goal is to generate the income I need from interest and dividends without, hopefully, touching the principal of the original investment. I don’t see this as that much different from a non-TRS ETF, with line item dividends, provided that one can equate the change in the TRS unit price to the underlying distributions (also factoring in any unit price depreciation in a falling market).

    Of course, one might say that you might as well just invest in an ETF that pays dividends as cash that can then be used for income but then you are giving up the tax advantage of the TRS.

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