The Magic Trick of Swap-Based ETFs

swap-based ETF benefits

Watch very closely while I make the investment income disappear. Magic!

There are ways to make investment income disappear. I am not talking about investing with someone who takes your money and absconds to some lawless country with better weather. Nor am I talking about losing money by giving into emotions and making poor investment decisions – that is all too easy. I am talking about making one type of investment income disappear and reappear as something different.

Not all investment income is treated equally

Interest is taxed at full marginal rates immediately, capital gains at half that rate and only when realized, with eligible dividend tax rates somewhere in between. Foreign dividends may be subject to foreign withholding taxes in their country of origin (which may or may not be recoverable in Canada) and are also taxed unfavourably – like interest income.

There would be obvious advantages if you could make interest and dividends disappear and re-materialize as unrealized capital gains:

  • In a personal taxable cash account, the advantages would be tax deferral and reduction.
  • In a Canadian Controlled Private Corporation (CCPC), such as a professional corporation,  the advantages would be tax deferral, tax reduction, and a way to avoid losing the favourable small business tax rate that results from making too much adjusted aggregate investment income.

This can be done using swap-based Horizon’s Total Return Index Exchange Traded Funds (TRI ETFs) or Corporate Class Mutual Funds.

how swap ETF works
Adapted from The Wizard of Oz, 1939, Metro-Goldwyn-Meyer

Both are complex and seem to perform magic behind a curtain.

A swap-based ETF passively tracks the total return (change in capital plus dividends/interest) of an index with the low fees expected of an ETF (0.03% to 0.5%).

A Corporate Class Mutual fund is actively managed and structured to minimize income and capital gains distributions to maximize deferred capital gains. They have the usual higher mutual fund level fees with a small premium on top of that because of the extra corporate structure (1% plus high net worth advisor fee or 2.2% to 3% retail price).

One of the first rules of investing is to avoid buying investment products that you don’t understand. It is even the first item on White Coat Investor’s recent Investing 101 post and although it seems obvious – many doctors and other high income professionals do this all the time! Swap-based ETFs seem attractive, but let’s not commit this sin. 

Let’s learn about them, so that we can weigh whether they may have a place in our portfolio planning. One of my goals with Loonie Doctor is to explain complex topics that you can’t just get a grasp on using a few minutes with a Google search. There is a reason why some things are hard to find… Brace yourself.

What is a swap-based ETF?

It is a synthetic ETF. The synthetic part means that it actually doesn’t hold any stocks or funds. It is a derivative which means that it is a contract between two or more parties with a price based on an underlying asset. Aaahhhh!!! Sounds scary. Didn’t derivatives cause the global financial crisis!?! Mortgage-backed securities are the derivatives that were blamed for triggering the big 2008 market meltdown. It was bad debt wrapped up in pretty paper with a bow on it. Options and futures contracts are also derivatives. They are used all the time to lubricate the wheels of the markets. Derivatives all have risks, like any investment, but the key is in understanding the risks of the underlying asset and the contract. So, let’s explore that.

A swap-based ETF uses a contract, between the ETF company and a bank, called a total return swap. The funds using this structure are also sometimes called Total Return Index (TRI) Funds. The only company doing this in Canada is Horizon ETFs and they are contracting with National Bank. So, I will explicitly use them in my descriptions.

How does a total return swap contract work?

The ETF company holds the cash that they receive in a custodial account and pledge it as collateral to the bank without giving it to them. The ETF company gets interest on the money in the custodial account at the prevailing inter-bank lending rate (CDOR).

The bank then buys the stocks in the index being tracked and reinvests any dividends/interest – therefore generating the total return of the index and being hedged against the market return with actual assets.

If the prevailing interest rate is greater than the total return, then the ETF company pays the bank the difference. If the total return is greater, then the bank pays the ETF company the difference. So, Horizon only pays CDOR interest to National Bank or National Bank pays Horizon its obligated ITR payment. Horizon never receives dividends to pass through to the investor. The dividends are taxed favourably within the bank’s structure. This seizure-inducing process is outlined in the diagram below.

swap TRI ETF structure

I have to be honest. Sometimes, even with knowing how a trick is done, it can still seem like magic!

The value of the swap-based ETF is “marked-to-market” to give its “net asset value” (NAV). This back and forth of debt obligations can result in either the Horizon ETF owing or being owed money on a day to day basis. This is called counter-party exposure if the amount of the ETF NAV is different from the amount actually held in the custodial cash account. By regulation, the counter-party exposure cannot exceed 10% of NAV. What does this mean in practical terms? It means that there are some risks which we will explore in the next post.

With the expansion of swap-based ETFs into foreign markets, there are also a couple of other factors to be aware of.

Currency exchange: These ETFs are valued in Canadian Dollars (CAD), so there can be fluctations due to changes in CAD relative to the currencies of the markets invested in. This would be true with any ETF. The difference with swap-based ETFs is that they charge a swap fee of about 0.30% on an ongoing basis on top of the managment fee. When buying a tradition ETF, there would be no extra currency exchange fee if it is listed on the Canadian market and any exchange costs would be within the management fee. If buying a foreign listed ETF (like a US  one), you would pay an exchange fee once when purchasing. The swap fee is a small ongoing drag on returns relative to buying and holding a traditional foreign ETF directly.

Foreign Withholding Taxes: Many countries charge an extra tax on dividends paid to foreign entities. This could be 15% of the dividend for US stocks or ~8-10% for other developed and emerging markets. If held in a personal taxable account, these withholding taxes paid are refundable if Canada has a tax treaty with the relevant country. They are partially refundable for CCPC accounts. One benefit of the swap-based ETFs tracking foreign markets is that since they do not receive dividends, there is no withholding tax.

So, if held in a registered account, the small drag of foreign withholding taxes is eliminated which counterbalances some of the sting of the 0.30% swap fee. This may not be important for an RRSP holding US assets since Canada and the US have a treaty that refunds the foreign withholding tax. However, the US withholding tax for TFSAs does apply, plus Canada may not have tax treaties with some emerging markets.

Some Fine Print: If you are using an investment loan (leverage) in a taxable account…

One fact to remember is that for you to deduct loan interest as an investing expense, the investment that you buy must be expected to produce income (capital gains does not count). That means that swap-based ETFs should not be the only investment that you have in an account using leverage. You need some investments that are expected to produce dividends, interest, or other income. Further, those income generating investments need to be clearly documented as being purchased with the loan money.

Swap-based ETFs have some big potential benefits, but they also have a complex structure that you need to understand the implications of if you plan to use them.

This post gave a general overview of the potential benefits of swap-based ETFs and how they work. Of course, all investments also have potential risks. Swap-based ETFs have some specific risks which we will explore in the next post.

How those risks and benefits fit into your individual situation will vary.

After these two general anatomy posts, I will spend some more time with swap-based ETFs in The Sim Lab to run some scenarios illustrating the potential benefits and what the consequences of some of the risks could look like in practical terms. Since Commander Spock was all booked up, I made an excel-based Portfolio Tax and Asset Allocation Calculator to help us out. The second tab in the calculator can be used for comparing swap-based ETFs to matched traditional ETFs for whatever province, income level, or account type that you want. It will only run on desktops – tablets and phones aren’t up to the task.

Yep. I make even Spock look pretty non-nerdy.

Disclosure: I hold HXT and HXX as part of my portfolio. I have no other relationship with Horizon or National Bank.

18 comments

  1. Hey LD! The outcome of total return seems simple but the process is not. I have been looking into these products lately, great timing.

    One thing that seems to stand out is that years down the road if one accumulates a large unrealized capital gain and had to pay up because of govt changes or an increased cap gains inclusion rate, after paying taxes there would likely be less money to have invested than if you had chosen a traditional etf and weren’t forced to realize the gains. In the end what’s compromised is the flexibility to spread taxes around in a preferential way.

    Also when considering the tax drag using swaps for foreign (non US equity) is most beneficial. But that said, it’s seems best to try and keep these holdings to your personal non registered account after filling rrsp and TFSA.

    1. Thanks Phil. There are a few risk that we will explore in my next post – the legislative one you mention is the one I worry most about. Some have a risk premium that may be worth it and others don’t. It is an interesting interplay between fees and taxes between the different index income types and account types.

  2. Thanks for the link to your Asset Allocation calculator. Really cool stuff. So why are you a doctor again? I definitely think you have other skillz here!

  3. nice summary, LD.

    I wonder about the adequacy of diversion for these ETFs other than S&P 500. have to look at the performance vs. the more general market.

    What do you think about using XBB to cover the bond portion of portfolio? I am not sure if it makes sense to invest in bonds now vs. gic.

    1. Excellent questions. I am actually sitting at my computer right now writing an article about comparing HBB vs a regular bond fund vs GIC. I am calculating the risk premium for those approaches. It is different for a personal taxable account and corporate account. It also varies depending on your income (for taxable) and a few different factors (for corporate). There are a bunch of inter-related concepts, so I am going to have to break it down into several posts. It is interesting for fixed income, but for some of the equity indexes, it is even more interesting. I found a few unexpected things that have me re-thinking some of my own portfolio strategy.

      1. I have been thinking about strategies/allocation as well. Historically, its recommended to have 20-40% in bond. Given the low expected future bond return, does it make sense just to park 20-40% of portfolio? Equity also seems highly valued. Should I use historical return of 7.2% or a more muted 4% (suggested by Bogle) for projection? Obviously these projections will make a tremendous difference 15-20 years out and affects retirement planning.

        Maybe I am thinking too much.

        1. I have struggled with this too. While I often use a traditional 60:40 split in my examples, I have a different approach to “equity:income” in my portfolio. I have been fairly aggressive given my youth and earning power. However, I am now starting to get “the willies” and starting to look more towards asset protection as much as growth. I have been underweight bonds the last couple of years because I have had a hard time buying bond funds when rates have been at historical lows and destined to rise. Yep, it is a bit of market timing in an asset allocation sense. I have been using 10% REITs, 20% rate reset preferred shares (they rise in value with rising rates and pay eligible dividends), and 10% bonds (mostly corporate) and 60% equity for the last couple of years. That approach is a bit aggressive and doesn’t have the volatility dampening as much as using more bonds historically does. I figure that we are about half way through the current tightening cycle and plan to start shifting to have about 20% bonds in the next year or so at the expense of decreasing my REITs, preferreds, and some equity. The interest rate would still be low historically if we are about half-way through this cycle, but I agree with all of the smart people predicting low yields for the foreseeable future. In terms of projecting, I just take a guess like everyone else and use 6% (4% after inflation) overall in my personal planning. However, I also plan to “oversave” because I don’t want to get caught having bad timing and starting to draw on the capital of my portfolio around the time of a major correction. Plus, I honestly like my job currently so making money is no problem and I have a good lifestyle while still being able to save vigorously – it will be good to have options if that changes.

          1. 6% and 4% after Inflation sounds reasonable, but it depends on the account, in a ccpc big difference than a Tfsa (taxes). I calculated each account separately based on what’s in them and then stretched out the time frame for projected totals. These returns would be prior to management costs.

          2. Agreed. I account for taxes when I do my projections also. With a CCPC, if you trigger your RDTOH refund each year by paying yourself enough dividends, then the tax drag is low (zero for eligible dividends and reasonably low for capital gains). Of course you pay personal tax on the disbursed dividends, but for me I am paying them out to fund my lifestyle anyway. I have no problems spending a salary plus some dividends 🙂 Keeping fees, taxes, and management costs low are the things we can control which is why I spend so much time fussing about them compared to worrying about my returns which I have limited control over (other than trying not to mess up behaviourly).

  4. GIC laddering is an option if you like GIC’s (or like watching paint dry). Buy a new 5 year GIC every year with 20% of your bond allocation. Initially you might want to buy 20% 1 year 20% 2 year 20% 3 year (etc) but once the first 5 year GIC’s matures you can purchase another 5 year every year.

    You won’t lose money if bond prices fall like a bond mutual fund or xbb would.

    1. Not much value in a 5 year gic right now. Now a 2 year gic can be found at a rate higher than a 5 year, two years ago:)

      1. Yeah. I have not bought into them either. I don’t like the fuss or having my money tied up with returns so close to inflation. I have a pretty high risk tolerance with my intensivist personality, youth on my side, and overall financial health. Those will factor differently for everyone.

  5. Good points. For physicians, I think it makes more sense to think of a modified FIRE. Most specialities allow for part time work that still places one in the highest tax bracket and I think most of us enjoy medicine to some degree as it took so long to get to to this point. So, a heavier focus on capital gain (allowing for CDA withdrawal) and part time work will eliminate almost all risks for a morbidly fat fire.

    1. I agree BC Doc. That’s what happened in 08/09 when physicians’ portfolios blew up. It was healthy to go to work to commiserate.

      I have read so much info re SORR and most of us do not have to worry about that.

  6. Hey LD,

    Wow! That is an impressive Portfolio Tax and Asset Allocation Calculator that you created! Thanks for sharing it! How long did it take you to make that?

    1. Thanks! I took a couple of stabs at it, but probably a week total. The tax optimizer piece was the most complicated part. It is actually pretty cool what excel can do. I keep learning new tricks.

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