Your Complete Guide to Index Investing with Dan Bortolotti

More Swap-Based ETFs on the Horizon

2017-12-02T23:18:52+00:00October 15th, 2013|Categories: ETFs, New products|Tags: |45 Comments

I have to admit I was skeptical when the Horizons S&P/TSX 60 (HXT) appeared back in September 2010. In an interview with a Horizons executive a few months later, I asked why the company would go head-to-head against the iShares S&P/TSX 60 (XIU), the largest ETF in the country.

It turns out HXT has become an extremely successful fund. Not only for Horizons’ bottom line (the fund now has close to $1 billion in assets and is the largest non-iShares ETF in the country), but for investors as well. As of September 30, its three-year annualized return was 3.75%, compared with 3.81% for the S&P/TSX 60 Index. As tracking errors go, 0.06% is about as good as it gets. Over the same period, the venerable XIU returned 3.59% for an annual tracking error of 0.22%.

Swapping returns

HXT tracks its benchmark so tightly because it uses a total return swap: rather than holding the underlying stocks in the index, the fund has an agreement with a counterparty—in this case, National Bank of Canada—who agrees to deliver the full return of the S&P/TSX 60, including both price changes and dividends. (See my earlier posts for more about how swap-based ETFs work and their potential risks.)

The swap structure assumes all dividends are immediately reinvested and compounded, just like the index does. By contrast, funds like XIU receive cash payments and then reinvest them manually, which causes a slight drag. And because HXT’s management fee is just 0.07% (with a rebate of two basis points over the last 12 months), it can deliver the returns of its benchmark index with a trivial cost of $6 or $7 annually for every $10,000 invested.

The other key feature of swap-based ETFs is tax-efficiency. HXT distributes no dividends, so investors won’t pay any taxes until they ultimately sell the fund: at that time, any accrued growth will be taxed as a capital gain. For investors in higher tax brackets, capital gains are taxed even more favourably than eligible Canadian dividends, so this may result in actual tax savings rather than just deferral.

More swaps on their way

Until last month, the only swap-based ETFs in Canada were HXT and the Horizons S&P 500 (HXS), which uses the same structure for US stocks. However, Horizons recently launched two more swap-based ETFs tracking the most popular sectors in the Canadian equity market: the Horizons S&P/TSX Capped Energy (HXE) and the Horizons S&P/TSX Capped Financials (HXF).

The Couch Potato portfolios I recommend use total-market index funds wherever possible, so I normally don’t pay much attention to sector funds. And, really, does any Canadian investor need more concentration in energy and financials, which already make up 60% of the S&P/TSX 60? But the launch of these funds is significant for a couple of reasons.

The first is they represent what Horizons calls “the latest salvo in the Canadian ETF fee war.” Rather than creating funds with an alternative strategy, Horizons has again gone head-to-head with iShares. These new funds track the same indexes as XEG and XFN, respectively, but with management fees 20 basis points lower, as well as the promise of perfect index tracking and tax-efficiency. It will be interesting to see how successful they are in grabbing market share. This kind of competition has been good for ETF investors, and we should see fees trending even lower in the future.

Second, the launch of HXE and the HXF suggest that Canadian investors have accepted swap-based ETFs. When I first wrote about them over two years ago, many readers dismissed them as black magic and said they would never use them. But one of the reasons HXT has become a billion-dollar fund is its acceptance by institutional investors, such as pension funds, which tend to be among the smart money. That should help retail investors embrace them with more confidence.

Swap-based ETFs are common in Europe, but far less so in US and Canada. That may change if the ETF price wars continue and more investors become comfortable with their structure.

Disclosure: I have a small holding in HXT in one of my accounts.


  1. gil October 15, 2013 at 10:46 am

    I use both the HXT & HXS to avoid the OAS clawback.

    The dividend gross up is a killer.

    Also the returns are compound due to re-investment & no dividend pay out.

    I like to see Horizon expand to cover the other major Index: XIN, XEM & XQQ.

  2. Andrew Coyne October 15, 2013 at 2:30 pm

    Was going to go with VCN but really can’t see any reason not to buy HXT, especially since the broader Canadian market tracks so closely with the top 60.

  3. Canadian Couch Potato October 15, 2013 at 2:38 pm

    @Andrew: I’m not sure I agree. There is still some diversification benefit to using a total-market fund like VCN. The differences in returns will not be huge, but they are probably significant over the long term.

    This may be of interest:

  4. Andrew Coyne October 15, 2013 at 3:15 pm

    But outweighed, surely, by the tax and fee advantage?

  5. Andrew Coyne October 15, 2013 at 3:17 pm

    And diversification can be covered off through a “completion” fund like XMD (though it would be nice if there were something in that line with a lower MER).

  6. Park October 15, 2013 at 4:23 pm

    With these swap based funds, you are taking counterparty risk. Risk should be compensated. Only an individual investor can decide whether the lower tracking error and higher tax efficiency is adequate compensation for that risk.

    IMO, a greater risk is that the federal government will decide that this swap based structure is costing them too much tax revenue. The more successful these swap based funds become, the more likely that decision will occur. Raising taxes is always unpopular, but ending swap based funds may be one of the least politically costly ways to increase revenue.

    It is in the interest of iShares/BMO/Vanguard etc for this swap based structure to end, and I wouldn’t be surprised if they lobby accordingly. I could easily see them asking the federal government for a level playing field.

    Remember income trusts?

    If the swap based structure ends, there may be a lot of capital gains tax to pay.

  7. Nooob October 15, 2013 at 4:28 pm

    Not too familiar with this stuff and not sure if I’m being facetious/paranoid, but compared to ETFs with forward contracts sounds like the banks just gave themselves a raise/fee increase with this new structure.

  8. Canadian Couch Potato October 15, 2013 at 5:22 pm

    @Park: Your concerns are legitimate, and as you say, every investor will need to decide whether the risks are worth it.

    In my opinion, the counterparty risk is extremely small. This older post goes into the details:

    As for the potential for changes to the tax laws, that is certainly possible. However, in the past, changes to these laws have been implemented gradually. Not just with income trusts, but more recently with forward agreements:

    If the government decides it wants to disallow the use of swaps, it’s highly unlikely holders of HXT would be on the hook for any gains earned in the past. It’s far more likely that the government would announce a date for the changes to take place and the worst case scenario is you would need to sell the ETF and pay the capital gains tax, but you would have had to pay that eventually anyway.

  9. Park October 15, 2013 at 5:40 pm

    The counterparty risk is very small. But it’s going to most likely show up when you least want it to, in the middle of a bad bear market. If the government decides to bail out a bank, I doubt that the bailout will include swap agreements.

    I agree that the worst case scenario is the loss of tax deferral. But that may more than negate the present tax advantages of swap based ETFs.

  10. Que October 15, 2013 at 6:54 pm

    As I was reading your post Dan, I was hoping you were going to say they were announcing that Horizons is going to launch a fund equivalent to iShares S&P/TSX Completion (XMD), maybe call it HXM? I can’t be the only one holding XMD in my Non-Registered account, thinking it would be really nice to have a tax friendly alternative.

  11. Ikran October 15, 2013 at 7:04 pm

    I don’t profess to understand these but

    @Park: if the worst case scenario occurs in the middle of a bear market, i.e. when the index is at a low point, wouldn’t that then reduce the capital gains liability, should one be forced to then have to sell the swap based ETF (i.e. relative to a bull market). So why would it more than negate the present tax advantages. I can’t see how one can conclusively say it will be either better or worse – surely it depends on the specific circumstances for each investor/investment.

    @Canadian Couch Potato: Apologies if this is a stupid question. Can you explain how the distributions piece plays into the overall performance of the non-swap and the swap funds. Does your comparison in performance account for the distributions received with the non-swap fund?

  12. KISS October 15, 2013 at 9:37 pm

    Do you have similar tracking information on HXS? The tax drag on dividends paid by non-Canadian securities is significant. If the underlying swap structure efficiently and successfully converts dividends into capital gains, the benefits for holders of HXS should be substantially better even than for holders of HXT.

  13. Be'en October 16, 2013 at 2:59 am

    I tried to buy some units of HXS several times but the orders did not get filled. The attempts were made over several days through Questrade, but none got filled. Could this be due to liquidity issues? Is HXS traded very thinly on any given day? Limits were placed at the ask rate.

  14. André October 16, 2013 at 6:10 am

    Does a swap-based ETF exist for the US market? That might solve the issue on witholding tax…Right?

  15. Canadian Couch Potato October 16, 2013 at 8:30 am

    @Ikran: Not a stupid question at all. Reported fund returns always assume reinvested dividends, so the comparison is fair. But remember, if you receive the ETF distributions in cash and you don’t have a DRIP set up, you don’t actually get the precise return reported like you would with a mutual fund that automatically reinvests all distributions.

    @KISS: The performance numbers for HXS are problematic now because the fund used currency hedging until April 1 of this year, so it would have two different benchmarks. HXS includes both a management fee (0.15%) and a swap fee of 0.30%, so one should expect the tracking error to be at least 45 basis points. But as you say, because the dividends from US stocks are fully taxable, the tax benefit is potentially greater for HXS than with HXT.

    @Be’en: No matter how thinly traded an ETF is, your buy order will always be filled if the limit price is above the current market price. When you place a limit order you should usually give yourself a few cents leeway: remember, if the market price is lower than your limit, you will still get the better price. This post may clear things up:

    @André: HXS does not incur withholding taxes, but you do pay an additional fee of 0.30%, which negates most of that benefit. And remember, swap-based ETFs are designed for taxable accounts where the withholding tax is recoverable anyway.

  16. KISS October 16, 2013 at 9:25 am

    Thank you, I wasn’t aware of the .30% swap fee on HXS. Together with the .15% MER, one should expect a tracking error of about .45%.

    I recently purchased Vanguard’s new total market VUN in my TFSA. I’m guesstimating its tracking error at the same .45% (.15% MER plus 15% withholding tax on an estimated dividend distribution of 2%). I thought HXS might do better, but it appears not.

  17. Park October 16, 2013 at 9:53 am

    ” if the worst case scenario occurs in the middle of a bear market, i.e. when the index is at a low point, wouldn’t that then reduce the capital gains liability, should one be forced to then have to sell the swap based ETF (i.e. relative to a bull market). So why would it more than negate the present tax advantages. I can’t see how one can conclusively say it will be either better or worse – surely it depends on the specific circumstances for each investor/investment.”

    About the worse case scenario, that is about the counterparty risk.

    There is a separate risk here. With swap based ETFs, dividend return is converted into capital gains, which can be deferred if the investor doesn’t sell the ETF. This may decrease the tax that the investor pays. The risk is that the government will stop this form of tax arbitrage.

  18. Park October 16, 2013 at 10:05 am

    These swap based structures remind me of ETNs more than ETFs. Lehman Brothers had 3 ETNs. I haven’t heard any recent news about what happened to those ETN investors, but in 2011 at least, it was uncertain if they were going to get their money back.

  19. Canadian Couch Potato October 16, 2013 at 10:10 am

    @Park: There is nothing wrong with choosing to avoid swap-based ETFs if you’re not comfortable with them. But it’s important to understand the risks clearly. A swap-based ETF is nothing like an exchange-traded note. Horizons addresses this question specifically in this interview:

  20. KISS October 16, 2013 at 11:10 am

    Do the new swap-based ETFs (HXE and HXF) charge a swap fee? With a swap fee (30 bps?), these new products cost much the same as ishares’ energy and finance sector ETFs. Without a swap fee, these new products are quite a bit cheaper.

  21. Canadian Couch Potato October 16, 2013 at 11:19 am

    @KISS: There’s no swap fee on the new ETFs. From the prospectus: “The Manager currently anticipates that under the Swaps for Horizons HXE and Horizons HXF, such ETFs will not make any fee payments to the Counterparty in respect of the value of the applicable Swap.”

  22. Andrew B October 16, 2013 at 11:40 am

    There doesn’t seem to be much place for HXS with it’s 0.30% swap fee in registered accounts, but would it be the optimal solution to someone who is planning to place their US equities in a TFSA? Or RRSP for that matter, if they are not willing to use USD and purchase VTI.

    I suppose the swap fee makes it a wash in comparison to the foreign dividend withholding tax, and VUN would be broader in any case, and therefore more ideal.

  23. Canadian Couch Potato October 16, 2013 at 11:47 am

    @Andrew B: I think you’ve answered your own question. The withholding tax isn’t a significant issue with HXS: any theoretical withholding tax savings are almost entirely offset by the swap fee. In a registered account, a plain-vanilla ETF is likely to be a better choice.

  24. Andrew B October 16, 2013 at 12:20 pm

    @CCP: I only came to that conclusion by educating myself on your blog, so thank you!

    If only someone came out with a much cheaper XMD, or HXS’s swap fee was halved or eliminated, I think both HXT and HXS would be far more useful to DIY’ers.

  25. Park October 16, 2013 at 2:24 pm

    “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”

    I stand corrected. Swap based ETFs are quite different than ETNs, although they still strike me as more of a structured product, rather than an ETF.

    The link that you graciously provided also gives the reason why a bank would be interested in being a counterparty: tax arbitrage (see above). National Bank, Horizons and retail investors all come out ahead, at the expense of the federal government. Since the federal government sets the rules, I would not assume that this will continue indefinitely.

  26. Canadian Couch Potato October 16, 2013 at 5:46 pm

    @Park: The key idea here is that there is no tax avoidance. The taxes are paid on the counterparty’s side, so the federal government is getting its fair share and should have no incentive to crack down on this structure because of lost revenue. That was not the case with income trusts and forward agreements, which really did affect the government’s bottom line.

    There’s no free lunch: you’re gaining a tax advantage in exchange for assuming some counterparty risk.

  27. Jim October 18, 2013 at 11:54 am

    Do you think there will ever be swap-based ETFs that track bond indexes? Like a swap-based version of XCB? Or is that even possible? I’m still trying to wrap my head around how these things work.

  28. Canadian Couch Potato October 18, 2013 at 12:05 pm

    @Jim: My guess is this structure won’t work for bonds, because it’s based on a tax arbitrage that wouldn’t exist for interest income. There were ETFs that attempted something similar for bonds (using a different kind of derivative), but the federal government put an end to that with the 2013 budget:

  29. Dan Hallett October 18, 2013 at 2:54 pm

    I’ve only scanned the comments but I’m not sure if this notion of counterparty risk – of the worst case variety – has been fully addressed. So I will take the liberty of linking below to an old discussion on HXT from the Financial Webring Forum. The link should take you to a starting point dealing with this issue. It will start with a question about counterparty risk and comparisons with ETNs and it’s followed by my reply.

    The short version is that the ETF’s capital is not at risk if the counterparty fails. Only amounts equal to the net return payments are at risk of being lost. But the counterparty is unlikely to owe the ETF anything all that material, if anything, in the event of a bear market. Because in a bear market, the index returns that they’ve supposed to deliver to the ETF will be very negative!

  30. Canadian Couch Potato October 18, 2013 at 3:23 pm

    @Dan H: Thanks for stressing this important point. I’ll quote from my interview with Jaime Purvis of Horizons, which is linked in the original post:

    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.

  31. Jack October 20, 2013 at 1:42 pm

    Working in the industry, there are a lot of a lot of misconceptions among retail investors as to what exactly ETFs are. Two of the biggest are that 1) ETFs have to track an index’s performance; and 2) in order to do so, need to own the index’s constituent issuers. Both are fallacies. Remember, ultimately, that “ETF” is just an acronym for Exchange Traded Fund, “fund” being the operative word, i.e. a pool of investor money used to invest in assets. They can be invested in any number of assets, can be passively or actively managed (more prevalent in the US but also available in Canada), and can use all manner of equities/fixed income/derivatives/hard assets to meet their investment objectives. They are, in actuality, mutual funds, only with a different delivery mechanism. Rather than being offered through the broker/advisor/dealer network, these funds are offered over the stock exchange. In Canada, they are typically governed by the same rules and regulations that cover mutual funds (I say typically, because some products fall under Commodity Pool regulations) and, because they are exchange traded, also need to comply with the listing exchange’s regulations.

  32. mtddc November 14, 2013 at 6:32 am

    I noticed that HXT is in your recommended ETF list while HXS is not. Is this simply related to the “newness” of this ETF or is there some other reason that it hasn’t yet made the cut?

  33. ETFinvestor December 21, 2013 at 2:45 pm

    How come HXT outperforms the S&P 60 so much?

  34. LawrenceW February 14, 2014 at 10:35 am

    Anyone can tell me wich one is the best pick for long term hold (in taxable account)


    is there any comparative spreadsheet ?


  35. Oldie March 11, 2014 at 7:53 pm

    @CCP: It seemed obvious to me that for anyone above the lowest tax brackets with a sizeable non-Registered investment account, if an investment tracking the S&P500 was an acceptable part of your asset allocation strategy, and if the tracking was exact, HXS would be a winner. The only unknown was assessing the accuracy of the tracking, especially after Horizons changed from a hedged to non hedged approach in April last year. Do you think enough time has passed to pass a judgement on the accuracy of the tracking of HXS?

  36. Francois April 9, 2014 at 8:31 am


    For my non-registered account, I don’t want to pay taxes on any distributions and to have different kind of distributions to report to my taxes report.

    So, I only hold HXT and HXS.
    I was wondering if holding HXE and HXF could be a good idea for diversification?

  37. Canadian Couch Potato April 9, 2014 at 9:47 am

    @Francois: Adding more energy and financials to a Canada-heavy portfolio just makes it less diversified, in my opinion.

  38. Steven February 11, 2015 at 4:05 pm

    Horizon’s web site (and customer service line) says since there are no distributions on HXS/HXS.U, there is no 15% US withholding tax. Strictly speaking I suppose that’s true – you’re not going to get a tax slip showing how much foreign tax was paid. But somewhere along the line, probably through their swap holder (National Bank), the U.S. company sending dividends across the border must by law, withhold 15% – correct?

    If so, the distribution amounts getting dumped into the NAV (or the swap agreement Horizon has with National Bank), must be reducing the NAV by the 15% – is this not correct?

    If so, might we not actually be worse off, since we’re not able to claim any foreign tax credit on the NAV reduction?

    Comments please.

  39. Canadian Couch Potato February 11, 2015 at 4:18 pm

    @Steven: HXS has an additional “swap fee” of 0.30% on top of its MER. This is approximately the amount as the withholding taxes on a 2% yield, so the net cost is virtually the same. You’re not worse off, since the foreign tax credit just prevents double taxation (i.e. being taxed on the same income by both the US and Canada).

  40. Steven February 11, 2015 at 4:26 pm

    Thanks – but since we’re not getting the foreign tax credit on HXS aren’t we in fact being taxed once (via the 0.30% swap fee), and then a second time via the capital gain when we sell?

  41. Canadian Couch Potato February 11, 2015 at 8:08 pm

    @Steven: The situation is no different from any other fund that charges an MER. Your gains are reduced by the amount of the fee, and the remainder is taxable. For high income earners the cost is still likely to be lower with HXS because the dividends are re-characterized as capital gains, which are taxed at only half the rate of the dividends. The higher the yield on US stocks, the greater this advantage would be. There is also some benefit from being able to defer those capital gains indefinitely.

  42. Gehrig July 18, 2018 at 9:47 am

    How much of a difference can the tax savings of a swap based ETF actually make? In general, with the management fees and swap fees combined, they end up being more expensive than traditional ETF indexes, so obviously the higher recurring fees would have to be offset by the tax savings.

    Would it be fair to say 0.5% savings on taxes?

  43. Martin Mck October 4, 2018 at 10:47 am

    As a Canadian expat investor, I am wary to have any of my investments tied up in US registered financial products. As it currently stands, I believe that Non-US residents are on the hook for U.S. based assets over $60,000 USD which will be taxed at 40% All other risks aside, does the ETF swap option for a product such as HXS provide a loophole on U.S. estate taxes?

    My investment banking is not done through Canadian banks and as an expat, I have yet to fully explore my residing countries tax treaties with the US but if possible, I would like to avoid as much exposure as I can to US estate taxes. It seems to me that they are making a mint off of their foreign investors.

  44. Canadian Couch Potato October 4, 2018 at 11:58 am

    @Martin: I cannot offer any tax advice, but HXS is a Canadian-listed ETF and therefore is not considered among “US situs assets.” This is also true of any Canadian-listed ETF or mutual fund that holds US stocks, so there’s no “loophole.”

  45. Martin Mck October 5, 2018 at 8:33 am

    @CCP Thanks for the clarification. I needed that. I know I had seen that somewhere in my research before but it can be difficult to keep it all straight sometimes. It seems a fine line that a Canadian company offering products comprised entirely of U.S. based companies can be exempt, especially as the withholding tax applies on dividends from those U.S. companies.

    It’s a great investment resource you have here and very much appreciated!

    All the best, Martin

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