This much we know: The more taxes you pay, the less money you keep. As opposed to trying to forecast future market trends – typically an exercise in futility – there are many perfectly sensible strategies aimed at minimizing the taxes due on your investments. Investing in swap-based ETFs is one such strategy that may merit your consideration … as well as your comprehension of the caveats involved.

Have I enticed you to learn more about swap-based ETFs? That’s what today’s post is for. Let’s get started.


The Swap-Based ETF: A Tax-Friendly Tactic

As the name implies, swap-based ETFs involve an exchange of one thing for another – in this case, a total return swap (TRS). A TRS is a structure where one party – in this case an ETF – enters into a swap contract with a counterparty – in this case, one or more Canadian banks – which plays out as follows:

  1. You invest your cash in a TRS ETF.
  2. The ETF deposits your cash into a custodial account.
  3. The cash in the custodial account earns interest at the Canadian Dollar Offered Rate, or CDOR.
  4. This interest is swapped to the counterparty/bank. In return, the bank is obligated to deliver to the ETF the total return of an index of stocks or bonds.
  5. The ETF adjusts the value of your investment by that total return.

Why would anyone enter into all that fancy footwork? In a word: taxes.

An index fund’s total return includes the return on its dividends + interest + capital gains. Stock dividends and bond interest is taxable income in the year received, which can be a substantial drag on returns held in taxable accounts – especially if your personal tax rate is on the high side.

Swap-based ETFs take all the dividends and interest, and turn them into deferred capital gains at your end. So, you get the index’s total return, but you receive it in the form of unrealized capital gains.

Unrealized, at least, until you sell fund units. But capital gains are more tax-efficient than dividends for high-income earners, and the tax deferral can increase your after-tax returns over time. Thus, your ultimate tax savings (if any) depend on your time horizon and tax rate when you sell. Ideally, you would hold this security for at least 30 years to maximize the tax deferral benefit. If it must be sold after, say, five years at your current tax rate, the annualized tax savings drop.

We’ll revisit your investment timeframe later. To summarize for now, by turning dividends into capital gains, swap-based ETFs can offer interesting tax-saving possibilities in your taxable accounts.

That said, as always, there also are a few risks to consider. Not to spoil the suspense, but I feel the most important caveats involve regulatory risk and effective diversification trade-offs. Keep reading to find out what I’m talking about. (Plus, my PWL colleague Dan Bortolotti has offered similar comments on the same subjects.)


Parties and Counterparties: What’s in It for Them?

Before we talk more about you and your tax savings, you may be wondering: What’s in it for the banks?

I mentioned earlier how the total return swap works. The counterparty is contractually obligated to deliver the total return of an index. In Canada, Horizons is the only TRS ETF provider. For HXT, its Canadian equity TRS ETF, they enter into a total return swap with National Bank and CIBC. So, National Bank or CIBC collect CDOR interest on HXT’s cash deposits, and deliver the total return of the S&P/TSX 60™ index to Horizons’ HXT.

If it weren’t managed properly, this could be risky for the banks. If the index surges, they have large payments to make to Horizons. To hedge this risk, the banks hold positions in the index’s stocks. Done well, this is a low-risk way for them to earn some revenue. The index’s equity returns earned and delivered should end up being a wash for them, with the CDOR collected representing a “profit.”

But … the need for the counterparties to hedge their exposure does have an important implication for the structure: The underlying securities must be liquid. This is an important point we will come back to later.

There’s another way the banks/counterparties can benefit from the swap. There’s a tax arbitrage they can tap for Canadian equities. For non-Canadian equities, Horizons instead adds an extra, modest charge to the management fee to perform the swap (an extra 30–35 bps). On the non-Canadian front, these additional costs eat into an investor’s tax savings, but there can still be a meaningful net savings in high income taxable and corporate accounts. To learn more on these points, check out the video version of today’s post.


Swap-Based ETFs: A Small-Cap Disappearing Act

Alright, that was an overview of how swap-based ETFs work. Deciding whether or not you want to include them in your portfolio comes down to some tradeoffs and risks.

I mentioned earlier that the banks will want to hedge their index exposure by owning the underlying securities, which requires those securities to be relatively liquid. Due to this, a TRS ETF is much less likely to hold the less-liquid small-cap stocks you might find in a plain, total market ETF. Those positions would be riskier for the counterparty to hedge their exposure to.

We see this reflected in Horizons’ TRS ETF products, which cover large-cap indexes like the S&P/TSX 60, the S&P 500, and the MSCI EAFE. Giving up exposure to small- and perhaps even some mid-cap stocks does have implications for the expected returns of the holding. To see this in action, join me as I explore the data in my video.

In comparing swap-based ETFs to traditional total market ETFs, I do think we need to account for some expected pre-tax underperformance due to the lack of small-cap exposure. To counter this point, we could use a swap-based ETF for large- and mid-cap exposure, and hold an additional fund for small-cap exposure. That is certainly true, but the cost of the added complexity is harder to quantify.


Recognizing Risks, Large and Small

Lower expected returns are one issue with these products, but the tax savings may still offer an advantage for taxable investors in a high-tax bracket – even after the swap fee and the implied cost of lower expected returns. Still, this advantage has to be weighed against a couple more risks related to swap-based ETFs.

First, there’s counterparty risk. That is, what if the counterparties/banks welch on their end of the deal? To make a long, legislative story short, keep in mind that individual counterparty risk is only on up to 10% of any gains; it doesn’t put your principal at risk. So, say you deposit $10,000 and earn $1,000 – and then the counterparty fails. You don’t lose the $10,000; you are only out the 10%, $1,000 gain.

Now, the $10,000 on deposit is not risk-free either. It is a bank deposit with credit risk of its own. In a real disaster, it’s possible your bank deposit wouldn’t be fully returned to you, which is not an issue that arises when you own the index directly.

These risks are greater than zero, but not huge – so, not among the major factors I would use to decide whether to include these products in a portfolio. Regulatory risk, on the other hand, gives me greater pause.


Regulatory Risks Over the Long Haul

 First, I want to remind you of an earlier statement: The tax benefits of TRS ETFs are expected to increase the longer you’re able to defer those unrealized capital gains. For a close-up analysis of this claim, I refer you to my video, where I will compare various scenarios and outcomes for the detail-oriented. For our purposes here, the longer the holding period, the more regulatory risks begin to matter – potentially in an important way.

Regulatory risk is the risk that the government decides swap-based ETFs are unfair, and must be shut down. This could result in you having to dispose of the holding earlier than planned. It wouldn’t be the first time similar risks have been realized.

This is where it gets interesting. I want you to stick with me now. This might take a minute to wrap your head around, but it’s probably the most important piece of information in this post.

HXDM is Horizons’ TSR ETF for tracking international developed markets. It does so by tracking the Horizons EAFE Futures Roll Index (Total Return). XEF is iShares’ similarly structured Core MSCI EAFE IMI Index ETF. It tracks the MSCI EAFE index, for exposure to large and mid-cap stocks in Europe, Australasia, and the Far East.

Similar to HXDM, XEF’s after-tax return increases the longer you hold it due to the unrealized capital gain portion of the return. In year one, XEF has a post-liquidation after-tax return of 4.43%. But if we hold until year 30, the annualized after-tax return increases to 4.93%. That is 4.93% per year on average. Now if we look at HXDM, its post-liquidation after-tax return in year one is 4.83%, which is notably less than the annualized post-liquidation after-tax return of XEF, assuming XEF is held for 30 years. It is not until year four that HXDM has an advantage.

So, to cut some likely confusion:

  • If we compare selling both XEF and HXDM in any given year, HXDM always wins.
  • If we instead model holding XEF for 30 years before selling, while being forced to sell HXDM within four years, XEF has a higher annualized after-tax expected return.

In other words, a long-term investor needs to hold HXDM for at least four years to realize its tax-saving benefits. If regulators end up disallowing the structure, you may lose control over your holding period. That is the risk.

If we compare Horizons’ other TRS ETFs – HXT and HXS – the point remains the same. You need to hold HXT for at least five years, and HXS for at least 12 years to ensure their tax benefits can be realized.

By the way, all of this is assuming tax at the highest marginal rate in Ontario in 2019. At lower tax rates, the advantages are smaller, and the holding period required to lock in tax savings is longer.


Are Swap-Based ETFs Right for You?

If nothing else, swap-based ETFs are interesting products, and lots of fun for data-enthusiasts like me. If your only goal is improve your tax efficiency, they are compelling, especially if the regulatory risk evaporates. That said, it’s not evaporated yet, and the lack of small-cap stock exposure is also to be considered as you factor tax efficiency into your greater goals. It’s pleasant to pay fewer taxes, but is the trade-off worth it? Let me know what you think about that.