Total Return Swap-Based ETFs for Canadian Investors
Thinking about buying a swap-based ETF? Give this article a read first.
Investing in a tax-advantaged account like a Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) is relatively simple and straightforward – buy, hold, and sell.
Not so in a taxable account, where investors need to worry about things like adjusted cost basis, eligible vs non-eligible dividends, T3 slips, claiming foreign tax credits, etc. Adding to these headaches is the relative tax inefficiency of some assets, such as bonds and real estate investment trusts (REITs).
Thanks to some financial engineering, fund managers like Horizons ETFs have created a unique type of exchange-traded fund (ETF) in the last decade, one that boasts extreme tax efficiency and low tracking error.
Their suite of Total Return Index (TRI) ETFs has become immensely popular with Canadian investors and has attracted high assets under management. Are you considering investing in one? Read this guide first.
What is a TRI ETF?
"Vanilla" ETFs hold a basket of stocks/bonds/commodities. When you buy shares of that ETF, the creation/redemption process allocates a portion of that basket to you.
TRI ETFs are built differently. Each ETF is issued as a different share class in a corporate structure, significantly enhancing tax efficiency. Moreover, they obtain synthetic exposure to assets using a swap derivative. What does this mean?
Imagine you buy $100 of a TRI ETF. The fund's custodian holds your cash as collateral for Horizons entering into a swap agreement with a counterparty (a Schedule 1 Canadian bank).
The swap agreement obligates the counterparty to deliver to Horizons the total return of whatever index the ETF tracks. For example, if the S&P/TSX 60 returns 10% in capital gains and 2% in dividends in a year, the counterparty is obligated to pay that amount to Horizons.
You then receive this "total return," minus the management expense ratio (MER) and a swap fee for non-Canadian equities if the ETF holds them.
What Does Total Return Structure Mean?
Well, the total return structure means that little, if any, distributions are paid out. Investors who buy TRI ETFs can therefore avoid or minimize dividend tax and only pay capital gains tax when they sell the ETF.
TRI ETFs also offer an extremely low tracking error or the percentage that the ETF differs from the underlying index it tracks. The nature of total return swaps minimizes deviations as the counterparty is obligated to deliver accurate returns.
TRI ETFs also offer low fees. Swaps are extremely cheap to buy, and because no shares are being bought and sold, fund turnover is low. There is an additional swap fee on TRI ETFs that hold non-Canadian equities, but funny enough, that offsets the usual 15% foreign withholding tax on non-Canadian dividends.
What are the Risks of TRI ETFs?
There is a risk of Horizon's not receiving the returns of TRI ETFs from their counterparties, called counterparty risk. This is measured by counterparty exposure, which represents the net amount owed to or owed from Horizons counterparties as a percentage of the total net assets of a TRI ETF.
- If counterparty exposure is negative, the ETF is over-collateralized and owes that net amount to the counterparties.
- If counterparty exposure is positive, the ETF is owed that net amount by the counterparties.
Counterparty risk can also be thought of as credit risk – think of it as an amount outstanding and owed either way. Before January 3, 2019, there used to be investment regulations that capped counterparty exposure with any one counterparty at below 10% of the ETF's net asset value (NAV).
While this regulation is no longer in effect, I'm not personally worried about counterparty exposure. Horizon's counterparties are large Schedule 1 Canadian banks (National Bank and Canadian Imperial Bank of Commerce) with strong balance sheets and high creditworthiness.
The bigger risk I'd be worried about is regulatory change – the chance of the CRA cracking down on the corporate class structure TRI ETFs use to avoid distributions. If there's anything the government doesn't like, it's not receiving tax income.
This already happened once in 2019, when the Federal Budget talked about legislating against funds that convert ordinary income to capital gains. That being said, I have confidence in Horizons management and legal team regarding their ability to address these possibilities.
What Are Some Examples of TRI ETFs?
I used NEO Exchange's ETF screener to find a list of Horizons ETFs that use the TRI structure, covering Canadian, U.S., and global equity (asset allocation) strategies, listed in order of lowest to highest management expense ratio (MER):
- Horizons S&P/TSX 60 Index ETF (HXT): 0.04% MER.
- Horizons S&P 500 Index ETF (HSX): 0.10% MER, 0.10% swap fee.
- Horizons Growth TRI ETF Portfolio: 0.16% MER.
Disclaimer: This article is limited to the dissemination of general information pertaining to investment strategies and financial planning and does not constitute an offer to issue or sell, or a solicitation of an offer to subscribe, buy, or acquire an interest in, any securities, financial instruments or other services, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.
