Not so long ago, ETFs were simple and transparent. But with the tremendous growth in the industry, ETFs have not only become more numerous, but also more complex and opaque. A number of influential bodies—including the International Monetary Fund, the Financial Stability Board, and the US Senate—have expressed concerns about how ETFs might damage the global financial markets. As a Canadian ETF investor, should you be worried about the funds in your portfolio?
In a series of three posts, I’ll take a look at the major concerns and try to give some perspective, with a specific focus on Canadian ETFs. Let’s kick off with a look at the new breed of “synthetic ETFs.”
Synthetic ETFs use a derivative called a total return swap to get exposure to the indexes they track. The ETF provider enters into a deal with a counterparty (usually a bank) who agrees to deliver the precise return of the index, minus a fee. While the swap structure has many potential benefits—including lower cost, smaller tracking error, and tax efficiency—it also introduces counterparty risk. If the bank fails to deliver the promised returns of the index, investors in the ETF may suffer losses.
To mitigate this risk, regulators require the counterparty to post collateral. If the counterparty were to default on its obligation, the ETF provider would have a claim to the collateral, and investors who redeem their shares should receive full market value. But there are several potential problems:
- The bank’s collateral may be assets that are illiquid or of low quality. If the ETF provider has to sell this collateral in order to redeem shares during a period of financial turmoil, it may be unable to do so.
- Some of Europe’s biggest providers of swap-based ETFs are banks (such as Deutsche Bank and Société Générale), and their counterparties may be the asset-management arms of those same banks. There are potential conflicts of interest here: for example, a bank may find it convenient to use its most illiquid assets as a basket of collateral for one of its own ETFs.
- At least half of all European ETF assets are now in synthetic products, and all of that counterparty exposure may create a systemic risk. If all of the banks have derivative agreements with one another, one counterparty failure could trigger a domino effect, as it did during the mortgage meltdown.
What Canadians need to know
Despite their popularity overseas, there are only two swap-based ETFs in Canada: Horizons S&P/TSX 60 (HXT) and Horizons S&P 500 (HXS), both of which use the National Bank of Canada as the counterparty. With the above risks in mind, consider the following:
- While it is certainly possible that a major Canadian bank could become bankrupt, most people would consider that risk remote. If you would buy stock in National Bank, you should feel comfortable buying an ETF backed by the bank’s credit.
- Horizons and National Bank are not unaffiliated: National Bank Financial owns 20% of AlphaPro Management, a division of Jovian Capital, Horizons’ parent company. Clearly all the parties have an incentive to monitor each other’s financial health to protect their interests, but investors should be aware of the relationship. Ideally an ETF provider should use more than one counterparty to spread out the risk, and Horizons has said it plans to do this when the ETFs grow large enough.
- Under Canadian mutual fund regulations, counterparty exposure cannot exceed 10% of a fund’s assets. This means that even if the counterparty did fail, the worst-case scenario is that an investor would recover 90% of the index’s current value.
- The collateral provided to Horizons consists of high-quality, liquid money market instruments. In the unlikely event of a counterparty default, there should be no difficulty in selling this collateral to redeem the shares of the ETF.
- Horizons’ two swap-based ETFs have a total of just $325 million in assets, less than 1% of the Canadian ETF market share. If there is any concern about the overall counterparty risk in the Canadian financial markets, ETFs are a drop in the ocean.
If you’re interested in learning more about how synthetic ETFs works, Horizons has produced a clearly written educational report. But if you’re intimidated by the whole idea, or if you think they’re too risky, then don’t use HXT or HXS in your portfolio. Stick to traditional ETFs that hold the stocks in the index directly, such as the iShares S&P/TSX 60 (XIU) and the iShares S&P 500 (XSP). It’s as simple as that.
The concerns about synthetic ETFs are legitimate, but they are mostly problems for European regulators to sort out. Unfortunately, if there is a financial crisis triggered by synthetic ETFs overseas, you will be affected no matter what you hold in your portfolio. Let’s hope the regulators do their jobs effectively.
Hey Dan, here is the question you knew somebody would ask, and I apologize in advance for my rant. Why even take the risk to begin with??
Horizon HXT and HXS as you point out use the Total Return Swap to gaurantee the index return for investors. Sure you are geting a very low MER (Managment Expense Ratio) of 0.07% . But really why not just buy a product like XIU which actually buys the securites it invests in, for an MER of 0.17%. Really is the savings in MER of 0.10% worth it?
I’m not an industry or investment professional, but the level of complexity in Syntehtic ETFs (such as Horizon’s HXT) is not comforting to me at all. It is just more layers of leverage on a non-existent product (it doesn’t actually own anything – whether it is placing collateral for the swap). It is always layers of leverage that innevitably become a house of cards. What if we end up with 5 of these ETFs in Canada? What do they acutally own, who owes what to whom, and what is the magnitude of leverage ? I don’t think anybody will really know…
The Canadian Banks (and Australian banks) have been lucky so far, unlike their US or European counterparts – but that by no means suggests they always will be. If there are problems down the road for National Bank (no matter how remote that may seem today), HXT and HXS are potential canaries. And the fact that National Bank is intertwined with Jovian capital and Horizon’s to the degree it is, leaves me even less comforted with the arrangement. Whereas a product like XIU, for the most part, actually owns the stocks directly. You covered the possible risk of default in a previous post:
I just think there are better alternatives for investors such as ETFs which for the most part actually buy the securities they are investing in – I think XIU is a good example, many other indexed ETFs, as are e-series funds, albiet with a higher MER of course. Granted these products do use some futures to mitigate tracking error, as we have discussed before, but they are not total swaps. A Total Swap ETF in my opinion is not an investment without risk. Why buy a Total Swap ETF for the mere MER savings?
The Dividend Ninja
Thanks for the nice article. I look forward to the next two in the series.
The most interesting thing you mentioned is the potential tax advantages to these synthetic ETFs. Can you elaborate on that in the next posts? I am curious as to how the taxman views gains from XIU or XIC vs. those from HXT.
If there is a substantial difference, perhaps that would have a much bigger impact than any difference in the MERs.
@Raman: All of the gains in HXT and HXS are treated as capital gains, not dividends. Unlike dividends (which are taxed in the year you receive them) , capital gains can be deferred until the year you sell the shares. More info here:
@Ninja: All reasonable questions. The first point is that if the swap structure makes you nervous, or confused, or uncomfortable in any way, then forget it. Use XIU or XSP instead. There is nothing wrong with that decision at all.
However, in a taxable account, the long term savings may be more significant than just the lower MER. I actually asked Horizons about this in my interview. They’ve estimated that HXT can provide a tax savings of up to 50 basis points a year, while HXS may save 90 basis points:
I think it’s also important to remember that some financial instruments that seem complex to you and me are very simple to people in the industry. For starters, there is no leverage—let’s be clear on that. And it’s pretty clear what the fund owns: money-market instruments and a contract that entitles it to receive the total return of the underlying index.
Swaps are widely used by institutional investors, probably including your pension plan. Preet had an interesting take on this shortly after HXT came out:
Dan, thanx for the info. I wasn’t aware of Preet’s article, that really does clarify some of the basics :) Obviously the tax advantages of capital gains to dividends are huge. There certianly is a benefit here that outweighs the MER for investors wanting to index outside of registered plans.
Ok leverage is the wrong terminology here, granted.. but I don’t see the safety in the contract arrangement either – it is still a debt obligation, is it not? There is either going to be a gain or a shortfall depending on the underlying index. But your’re right about one thing, an ETF shake-up in Europe will affect all of us.
Great article Dan, looking forward to the others.
You’re definitely do the investing public a great service by providing in-depth information on ETFs. I agree that ETFs were once as plain as vanilla, but more recently, within the last 5 – 7 years, greed has set in which has spawned many complex ETFs that can be hazardous to a portfolio’s health if not well understood. What did you think of iShares recent white paper which provided recommendations for the ETF sector? Personally I think they were bang on in wanting the categorization of ETFs as opposed to it being a catch all label.
@Ninja: There’s no question there is a potential risk in that the counterparty may not be able to deliver the returns of the index. But there is high-quality collateral in place, and the counterparty risk is limited to 10%. As Preet explained, if the counterparty were to default during a period of financial turmoil (which would be the most likely cause of a default), the obligation would actually be to deliver a negative return! All of which is to say there’s certainly an added layer of risk, but it seems very small.
@Chad: Thanks for the comment. I tended to agree with what iShares had to say about transparency being the real key issue here. I do think they might have been a bit self-serving in reserving the term “ETF” for traditional structures only. :)
For readers interested in this white paper, here’s the link:
I’m kinda with the Ninja here Dan: why invest in complex products to begin with?
Much easier said than done I know Dan, but there’s a certain gut-check that comes with investing. As a DIY-er, if it looks complex and seems complex, I don’t touch it.
I only think we’ll see more complex products when it comes to ETFs over time. There are only so many XIUs and other plain vanilla ETFs that can compete with each other in this broad-market space. Hopefully that just means lower MERs for us :)
The work on your is excellent to demystify many complex ETF products, all in the name of raising awareness and promoting buyer-beware. Keep up the great work.
For HXS (S&P 500 hedged to CAD), does the total return swap not also eliminate any concern about tracking error due to the currency hedge that have been highlighted by several bloggers? That might be worth another 50 – 100 basis points.
I should also add that given the collateral provided for these swaps, these ETFs seem very low-risk to me indeed. I suppose the collateral can change without warning, no? Or is the collateral provided a feature of the prospectus?
@Andrew F: The types of collateral than can be used in the swap are regulated, and the prospectus specifies that Horizons will “invest the net proceeds of Unit subscriptions in cash and short-term debt obligations to earn prevailing short-term market interest rates.” So they can’t start using Detroit real estate as collateral.
Unfortunately HXS won’t eliminate the tracking error caused by currency hedging. It tracks the “S&P 500 Canadian Dollar Hedged Index,” which assumes that the hedge is reset every month. (This is the same index tracked by iShares XSP.) A fund with zero tracking error would deliver to Canadians the precise return of the S&P 500 in US dollars, which would involve adjusting the hedge daily and for free. In practice, of course, that’s impossible.
I believe Claymore has some swap based ETFs, too.
Also didn’t Jovian recently sell its stake in Horizon?
@Sean: Claymore’s Advantaged ETFs use forward agreements rather than swaps. They work a bit differently:
Jovian still as an interest in Horizons: