More swap-based ETFs on the horizon

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.