Are asset allocation ETFs cheap, well-diversified and convenient? Absolutely. Are they optimally tax-efficient? Perhaps not, though any tax edge you might get from using multiple ETFs and asset location strategies is likely to be outweighed by the additional costs and complexity. But what if there was an asset allocation ETF that promised better tax-efficiency without significantly higher fees or more moving parts?
That’s the promise of the one-ticket solutions from Horizons ETFs. They include a globally diversified mix of stocks and bonds in a single wrapper—just like their counterparts from Vanguard, iShares, and BMO—but with a unique twist. Most of the holdings are what Horizons calls Total Return Index ETFs (or TRIs), and all of them use a corporate class structure: both features are designed to pay no distributions, making them more tax-efficient than traditional ETFs.
|Horizons One-Ticket ETF||Asset Mix|
|Horizons Conservative TRI ETF Portfolio (HCON)||50% equities / 50% bonds|
|Horizons Balanced TRI ETF Portfolio (HBAL)||70% equities / 30% bonds|
|Horizons Growth TRI ETF Portfolio (HGRO)||100% equities|
Although the ticker symbols are similar to those used by other asset allocation ETFs, the stock/bond mixes are more aggressive in the Horizons family. Vanguard’s VBAL and iShares’ XBAL both hold 60% stocks, for example, but Horizons’ HBAL is 70%. Meanwhile, HGRO is 100% equities, making it comparable to VEQT and XEQT, rather than to VGRO or XGRO, both of which include 20% bonds.
There are many more differences between the Horizons one-ticket ETFs and their competitors. So let’s jump in.
On the equity side
We’ll start by looking at the equity side of the Horizons portfolios, and the easiest way to do this is to zero in on HGRO, which is all stocks. (HCON and HBAL use the same underlying ETFs in similar proportions in their equity portfolios.) HGRO uses six underlying equity ETFs to achieve global exposure:
|Asset class||Underlying ETF||Allocation|
|Canadian equities||Horizons S&P/TSX 60 Index ETF (HXT)||16.3%|
|US equities||Horizons US Large Cap Index ETF (HULC)||32.5%|
|Horizons NASDAQ-100 Index ETF (HXQ)||22.2%|
|International equities||Horizons International Developed Markets (HXDM)||14%|
|Horizons Europe 50 Index ETF (HXX)||7%|
|Emerging markets||Horizons Emerging Markets ETF (HXEM)||7.3%|
Source: Horizons ETFs, as of February 15, 2021
One of the first things you’ll notice is the high allocation to US stocks compared with the asset allocation ETFs from Vanguard and iShares. VEQT allocates about 41% to US equities, while XEQT gives the country a 48% share. The Horizons portfolios trump both with a 55% allocation.
That extra helping of US stocks comes at the expense of a much lower allocation to Canada. Whereas Vanguard and iShares assign roughly equal amounts to Canadian and overseas stocks, Horizons gives homegrown equities just a 16% share, compared with 21% to international developed markets and a little over 7% to emerging markets. (The emerging markets holding is a new addition: Horizons launched HXEM last August.)
I asked Mark Noble, Horizons’ executive vice president of ETF strategy, why they decided on a relatively low allocation to Canada. He points out that one of the reasons to overweight domestic stocks is the favourable tax treatment of Canadian dividends. But (as we’ll discuss later) this isn’t an issue for the Horizons ETFs. “We have huge underweight on Canada relative to our competitors because we don’t need to be concerned with the ETFs’ dividends or taxation.”
Another reason Canadians might overweight domestic stocks is to reduce currency risk. But this is another way the Horizons ETFs differ from their competitors: the one-ticket ETFs use currency hedging for all the foreign equities.
Why track the NASDAQ?
All of the underlying ETFs in the Horizons portfolios are index funds, which is good news. However, not all of the funds track the broad market.
The US equity allocation in the Horizons ETFs includes two components. The largest is the Horizons US Large Cap Index ETF (HULC), which tracks a benchmark very similar to the S&P 500. But there is also a huge allocation to the Horizons NASDAQ-100 Index ETF (HXQ), which holds the 100 largest non-financial stocks on the NASDAQ exchange. This index is a media darling, but it’s poorly diversified and bears no resemblance to the broad US market: it doubles down on the technology sector, which makes up about half the index.
Why include such a large allocation to HXQ rather than simply using HULC for the entire US equity holding? Noble explains the decision was based on backtesting of rolling 20-year periods. “The NASDAQ-100 actually had the best historical risk/reward trade-off: better than the S&P 500. So we combined the US exposure between those two benchmarks.” He added: “This is a somewhat controversial strategic allocation decision, and probably the biggest point of differentiation with our competitors’ strategies.”
The Horizons Europe 50 Index ETF (HXX) is also an oddball: it tracks the 50 largest stocks in the Eurozone, which of course excludes the UK. I would have preferred to see only the Horizons International Developed Markets (HXDM) in the mix, as it tracks a much broader index including all overseas developed markets, similar to the MSCI EAFE Index.
The balance of bonds
Now it’s over to the fixed income side. As we’ve noted, HGRO includes no bonds at all, while HCON and HBAL hold 50% and 30%, respectively. This includes approximately two-thirds Canadian and one-third US bonds.
The Canadian bond allocation comes from the Horizons Canadian Select Universe Bond ETF (HBB), which is pegged to a broad-market index, similar to the flagship bond ETFs from Vanguard, iShares and BMO. Both one-ticket ETFs also include the Horizons US 7-10 Year Treasury Bond ETF (HTB), which gives you exposure to intermediate US government bonds, with the currency hedged to Canadian dollars.
Putting it all together, the overall asset mix for the three funds looks like this:
Source: Horizons ETFs, as of February 15, 2021
According to the funds’ literature, the asset mix will be revisited “on each semi-annual rebalance,” which occurs in January and July. But in practice, it has not changed much since the ETFs were launched in August 2018. The bond allocation in HCON and HBAL have remained at 50% and 30%, respectively, so the overall risk in the one-ticket ETFs has not crept up over time.
Getting down to brass tax
If you’ve been investigating the Horizons one-ticket ETFs, it’s probably not because you were attracted by the details of its asset mix. The big selling point, of course, is the promise of better tax-efficiency.
The potential for tax reduction in the Horizons portfolios comes from the fact that most of the underlying holdings are Total Return Index ETFs (TRIs), also called swap-based ETFs, that do not hold stocks and bonds directly. And all of the ETFs use the corporate class structure, which is different from traditional ETFs and mutual funds (which are trusts).
We don’t have the space here to provide a full explanation of these strategies: for the gory details, I’ll refer you to Horizons Swap ETFs: The Next Generation, which I wrote when Horizons adopted the corporate class structure for many of its ETFs in the fall of 2019. The company has also produced a useful FAQ outlining the potential advantages of both total return indexes and corporate class ETFs.
For now it’s enough to say that swap-based ETFs do not pay dividends or interest (which would be taxable every year), and instead convert all growth into capital gains, which can be deferred until you ultimately sell your units of the ETF. Corporate class ETFs are also designed to pay no distributions, and if they do occasionally make small payouts, they will be tax-friendly Canadian dividends or capital gains.
There’s no question this structure is more tax-efficient than traditional ETFs. But an apples-to-apples comparison with Horizons’ competitors would be extremely complicated, misleading, and not very useful.
It’s one thing to compare the Horizons S&P/TSX 60 Index ETF (HXT) to the iShares S&P/TSX 60 Index ETF (XIU), which track the same index. It’s another thing to try to measure, for example, whether HGRO is more tax-efficient than VEQT. Any comparison would need to account for the former’s much larger allocation to US stocks, which will have far more influence on performance. Any backtest would also have to acknowledge that emerging markets have only been part of the Horizons funds for a few months. And the different currency hedging strategies make any comparison even more problematic.
It’s worth noting that neither of the two US equity ETFs in the one-ticket portfolios use swaps: both the Horizons US Large Cap Index ETF (HULC) and the Horizons NASDAQ-100 Index ETF (HXQ) hold their stocks directly. The swap-based Horizons S&P 500 Index ETF (HXS) was replaced after the launch of HULC in February 2020, because the latter has a much lower fee (just 0.08%). In any case, thanks to the corporate class structure neither HULC nor HXQ are expected to make distributions.
Your year-end surprise
Which leads to one final note before we leave the tax discussion. You would expect a portfolio of total-return swaps and corporate class funds to pay little or no cash distributions: indeed, that’s the whole point. However, all three Horizons one-ticket ETFs made year-end distributions in both 2019 and 2020.
In some cases these were trivial amounts (less than a penny per share), but last year HCON distributed almost $0.10 per unit (about 0.75% of the fund’s value) and HGRO paid out over $0.17 (about 1.3%). Most of the distributions were capital gains, with small amounts of return of capital and “other income,” the latter of which is fully taxable.
|Horizons ETF||2019 cash distribution (per unit)||2020 cash distribution (per unit)|
What’s going on here? “The corporate class ETFs in the underlying holdings don’t make distributions,” Horizons’ Mark Noble confirms. However, HCON, HBAL and HGRO themselves are not corporate class ETFs: they use the same trust structure as traditional funds. As a result, they can realize capital gains when rebalancing the underlying holdings, and they may distribute taxable income as a result of managing the currency hedging. “In total, though,” says Noble, “the level of distributions and the tax liability of the ETFs is substantially lower than our competitors’ strategies.”
Counting the cost
If you’re doing a cost comparison of the Horizons asset allocation ETFs and their competitors, you need to understand the subtleties, and that’s not easy.
The management fee for HCON, HBAL and HGRO is given as 0% on the Horizons website, which is potentially misleading, and has been misinterpreted by some investors. This simply means that the one-ticket ETFs do not add a fee on top of those of the underlying holdings. (By contrast, Vanguard and iShares add a few extra basis points.) The site clearly adds that the funds are “subject to the fees of the underlying ETFs,” and indicates an MER of 0.15% or 0.16%.
But even that’s not the total cost. Many of the underlying ETFs also carry a “swap fee,” which is not reflected in the MER. It only shows up in the fund’s trading expense ratio (TER), which you’ll need to hunt for in the funds’ semi-annual reports. Last year, the three one-ticket ETFs reported TERs between 0.15% and 0.18%, pushing their overall costs to 0.29% to 0.34%.
It’s taken us a while to get here, but now let’s ask the only question that really matters: are the Horizons one-ticket ETFs an improvement on the asset allocation funds offered by Vanguard, iShares and BMO?
I don’t feel they have any place in a tax-sheltered account, such as an RRSP or TFSA. The only compelling argument you can make for the Horizons ETFs is in a non-registered account, where they are likely to be significantly more tax-efficient than their competitors.
If Horizons had stuck with a more traditional equity asset mix, this argument would have been stronger. For example, they could have created a fund that held only the Horizons S&P/TSX Capped Composite Index ETF (HXCN) for Canadian equities, either HXS or HULC for US equities, and a combination of HXDM and HXEM for overseas stocks, leaving all the currency unhedged. Such a portfolio would have been very similar to VEQT and XEQT, with much less in the way of taxable distributions.
Combine that equity lineup with the two swap-based fixed income ETFs in HBAL and HCON and you would certainly have a very tax-friendly balanced fund for non-registered accounts. That would have been enough to differentiate the Horizons funds from their competitors.
But the strategies used in these ETFs—the large allocation to the NASDAQ-100 index (and to a lesser extent the Europe 50 index) and the currency hedging—have added another layer to the decision. Anyone looking for more tax-efficiency will also need to change their investment strategy, and that’s letting the tail wag the dog.
Finally, anyone considering these ETFs should spend some time understanding their complicated structure. You won’t just be holding a portfolio of stocks and bonds: you’ll be getting the majority of your exposure from derivatives, which are confusing, and carry some additional risks. These include the possibility that the federal government may stop allowing these structures, as they have done with several other tax-advantaged investments in the past. As always, make sure you understand what you’re buying.