What are the pros and cons of swap-based ETFs?

Q: I’m interested in replicating the Couch Potato portfolio with swap-based ETFs. What are the pros and cons of this strategy, and would I be taking on any extra risk?

— Laura G., Collingwood, Ont.

A: A “swap-based ETF” is a type of exchange-traded fund that does not hold any stocks or bonds directly. The fund instead uses a financial instrument called a “total-return swap” designed to deliver the same performance as a specific index, including any increase or decrease in price and any dividends or interest received.

Let’s use the Horizons S&P/TSX 60 Index ETF (HXT) as an example. This popular ETF tracks an index of the 60 largest public companies in Canada, but it doesn’t actually hold any stocks. When you buy units of HXT, your investment is held in cash. Meanwhile, the ETF’s “counterparty” (another financial institution) pledges to deliver to the ETF the same total return as the index. However, swap-based ETFs do not pay dividends or interest in cash. So if the stocks in the S&P/TSX 60 index increase by 5% and pay a 2% dividend, HXT will increase in price by 7% (minus a small fee).

There are several advantages to building an ETF with a swap rather than holding the stocks or bonds directly. The first is tax-efficiency. The most important advantage of swap-based ETFs is their potential to defer or reduce taxes. As we’ve noted, these ETFs do not pay dividends or interest, which means you won’t be taxed on any income as long as you hold your units. All of the gains in the fund are considered capital gains, which are not taxable until you eventually sell the holding. And even then, capital gains are taxed at only half the rate of regular interest income and foreign dividends. (Canadian dividends enjoy favourable tax treatment too, but for high-income earners, capital gains are still taxed at a lower rate.)

The second benefit is extremely tight tracking of the index. Because the counterparty is obligated to deliver the same return as the index, swap-based ETFs mirror their benchmarks with remarkable consistency. Over the five years ending in February, the S&P/TSX 60 Index returned 7.99% annually, while HXT returned 7.94% for a minuscule difference of 0.05%.

The undeniable benefits of swap-based ETFs come with a couple of additional risks. One is that the counterparty will fail to pay a return equal to that of the index. But this risk is small: the counterparty for Horizons ETFs is National Bank of Canada, and it seems unlikely that a major Canadian bank would default on its obligation. Even then, the ETF uses your cash for collateral, so a failure to deliver the returns of the index would not mean your investment would go to zero.

Another risk that can’t be ignored is the possibility that the government will change the rules that give swap-based ETFs their tax advantages. In the last decade, that’s what happened with income trusts, corporate class mutual funds, and other ETF structures that tried to turn fully taxable income into capital gains. If that were to happen, investors in swap-based ETFs might be forced to liquidate their holding and realize all of those capital gains in a single year, which could cause a spike in their tax bill.

I’m also concerned that building a Couch Potato portfolio entirely from swap-based ETFs would sacrifice some diversification. In addition to HXT (which is now almost seven years old and boasts more than $1 billion in assets), Horizons also offer ETFs tracking the S&P 500 (large US stocks), the Euro Stoxx 50 (large European stocks) and even a fund that tracks the Canadian bond market. But a portfolio built from these funds would be missing mid- and small-cap stocks, the Asia-Pacific region (including Japan, Korea and Australia) and the emerging markets.

If you decide to use swap-based ETFs, make sure you understand the trade-offs and the additional risks. If you’re not completely comfortable with how these products work, plain-vanilla index funds or ETFs are a better choice.

—Dan Bortolotti, CFP, CIM, associate portfolio manager with PWL Capital in Toronto

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