HEQT’s Upcoming Massive Phantom Distribution

All-in-one asset allocation ETFs are an elegant solution for investors, and each of the major ETF providers has its own flavors to choose from. Global X (the artist formerly known as Horizons) had its own unique take with a tax-efficient suite for higher-income investors. The Global X ETFs hold a bundle of corporate-class ETFs. Corporate-class ETFs are not expected to make distributions. They accrue unrealized capital gains instead of annually taxable dividends or interest when working as intended. Last year, they changed the prospectus for their all-in-one ETFs to allow for distributions. This has left people wondering why the change and how it will manifest.

While HEQT has a portfolio of ETFs covering global markets, it is actually actively managed. That means the managers adjust the allocations to different markets. Those tactical changes, plus rebalancing, can result in capital gains. This year has had a lot, and Global X is predicting a large 9.52% “non-cash distribution” for HEQT for 2024. A massive phantom distribution. Sounds spooky, but is it?

How Did HEQT’s Holding Change?

One of the purported reasons why Global X changed its prospectus for it’s all-in-one ETFs was to allow them to hold different ETFs, besides the corporate class ones, that would pay out distributions. As a trust structure, HEQT has to pass that income on to unit holders. Same thing with any capital gains that are realized. Over the past year, HEQT’s holding have changed substantially. I will compare their 2023 year end report to Global X’s HEQT webpage on Dec 17, 2024.

There were some pretty big shifts. They trimmed the allocation to the Nasdaq 100 and Emerging Markets and added US small cap via the Russell 2000 (RSSX). The missing small-cap and overweighting of large-cap growth was one of my previous concerns with the ETF. They also shifted from all of the ETFs except HXT to their new conventional ETFs. That was to make it easier for them to do their planned distributions. The tax benefit of HULC & HXQ were marginal due to the loss of foreign withholding tax in the corporate class structure. HXDM and HXEM have substantial tax efficiency as corporate-class funds, particularly for those investing through a corporation. However, the shift to conventional ETFs for those does come with a substantial fee reduction and removes the corporate class management risks. Those ETFs also hold stocks directly which helps with withholding tax recovery.

The tax triggered by turnover in actively managed portfolios is one of the reasons why active management may lag behind a more passive approach. While Global X is using broad indexes rather than churning stocks, they look to have had a significant turnover: ~80% of the portfolio!!! That initially caused me a lot of concern until the rationale was explained. It wasn’t about index-picking or market-timing, but rather a restructuring. It was done to reconfigure the ETFs for a better way moving forward. Further, Global X doesn’t anticipate making this type of big move in the future.

Distribution of Capital Gains

---

Cash Distributions

HEQT has been paying out monthly distributions since their prospectus change. In 2023, they made the following distributions.

Basically, they paid out 2.5 cents per share every month. That was mostly capital gain, with a sprinkling of other investment income. I got that detailed breakdown of income from searching the TMX Canadian Tax Breakdown Reporting Service database. To use it, you go to that site, search your ETF using the search page option of your browser and then download the excel file of the T3 information. It contains macros, so you will need to save it to a “trusted folder” on your computer to use it.

The 2024 T3s will not be out until February 2025. However, in 2024, they continued with their 2.5 cent/share monthly distributions. Presumably, they will be some capital gains with more foreign dividends than previously given the conventional ETFs.

---

Non-Cash Distributions (Phantom Distributions)

With the amount of capital gains realized in 2024 to change up their portfolio, much of the money from selling and realizing those gains was re-invested in the ETF rather than paid out. Even though cash was not paid out to shareholders, the realized capital gains are taxable to shareholders. These “non-cash distributions” are sometimes called phantom distributions.

Even though you never saw money hit your account, it shows up on your T3 slip for tax season. That means that the included half (or two-thirds if over $250K of personal capital gains or all capital gains in a corporation) is added to your income and taxed at your marginal tax rates. Is that a big deal?

How Big Is HEQT’s Phantom Distribution?

The quick answer is that it is a Stay-Puff-Marshmallow-Man-sized ghost. Global X is estimating it at 9.52%.

For perspective, the phantom distributions from other asset allocation ETFs are typically zero. Last year, XEQT and ZEQT had no phantom distributions. Vanguard’s VEQT had a 0.15% phantom distribution.

In fairness, HEQT didn’t have one last year, either. Hopefully, this is a one-off event, and they won’t have anything higher on the PKE meter than a Slimer in future years.

---

Tax Drag From HEQT’s Phantom Distribution

The main attractive feature of Global X’s all-in-one ETF was initially supposed to be no taxable income each year. Just an accruing capital gain that you would only pay tax on down the road when you sell. Tax deferral and tax reduction are also important since capital gains are taxed at a lower rate than most investment income, with the exception of eligible dividends in the lower tax brackets. Then, they started making distributions of a small capital gain of about 1.65% per year. That was not a big deal, and with only half of that taxable, it’s a much smaller taxable income than other ETFs.

However, adding the 1.65% to a 9.52% phantom distribution makes for 11.17% in 2024. If half of that is taxable, it is 5.6%. If in a corporate investing account, it is 7.4%!! That is much higher than the 1.5-1.75% yield on XEQT and VEQT. The yield chasers may go yay, but anyone who pays taxes on investment income and understands the power of tax deferral will be less impressed.

---

The Loss of Tax Deferral

The higher tax on HEQT owners this year is not really an increased tax rate per se. It is tax due this year rather than some time in the future. Realizing capital gains earlier than you otherwise would have is a loss of tax deferral.

While you pay tax on the amount of the phantom distribution, you also get to add the amount of the phantom distribution to the adjusted cost base (ACB) of your ETF. The ACB is the cost paid for the ETF plus brokerage fees. A phantom distribution adds to the ACB. Conversely, if the ETF pays out a non-taxable “return of capital”, that lowers the ACB.

This is very important to understand because it reduces your tax in the future. A capital gain is calculated as the difference between the value at which an ETF is sold and its ACB. A higher ACB shrinks that difference and thus the capital gain. Downstream, that results in less capital gains tax. In the case of a phantom distribution, it is because you have already paid for some of it.

Importantly, ACB is often not tracked well, or at all, by brokerages and portfolio tracking software. People serious about tracking their ACB use either their own spreadsheet or adjustedcostbase.ca So, if you have HEQT or hold other ETFs that make phantom distributions, then you should consider that.

Avoiding the Phantom

---

Most people should sit tight. But avoid double taxation.

Someone who has been holding HEQT for a while is likely sitting on a bunch of unrealized capital gains, as the markets have been on a tear for the last couple of years. In that case, selling the ETF just to avoid the phantom distribution would not make sense. You’d be realizing more taxable capital gains now than the phantom distribution would trigger. Just be sure to add the phantom distribution to your ACB to avoid paying the capital gains tax a second time when you do sell.

---

What if I have a minuscule capital gain or even a loss?

If I had just recently bought HEQT and my capital gain was very small relative to the planned ~9.5% non-cash distribution, then I may consider selling it before the ex-dividend date and rebuying it afterward. That will still trigger capital gains tax this year, but if it is a lot less than the tax on 9.5% then I am ahead. If I were sitting on an unrealized loss on HEQT and did that, it would be a superficial loss. So, it is not usable to reduce my taxes, but at least I would dodge a 9.5% capital gain tax event in the current year. Usually, phantom distributions are so small that I wouldn’t even consider this. However, this is a big one.

One downside of trying to dodge a phantom distribution is missing time in the market. Being unlucky and missing some big up-days around the ex-dividend date would permanently decrease my return. Markets tend to go up more often than they go down. There are also the transaction costs of buying and selling to consider. I am not giving anyone specific advice. Just food for thought. I personally err on the side of inertia for this sort of thing.

The ex-dividend date is December 31st, 2024. So trades on December 27th would settle before then. Shares bought on December 31st would not get the phantom distribution. Unlike cash distributions, a non-cash distribution doesn’t decrease the value of the ETF shares. It is just passing through the capital gains tax bill from the year.

Is this a One-Off Event?

I have admittedly been a fan of HEQT. I use some of Global X’s corporate class ETFs individually, but the all-in-one seemed to be an elegant way to do that simply. However, this year’s moves really highlight that it is a more actively managed ETF than the other asset allocation ETFs. They have shifted asset allocation slightly each year for various reasons, but this year had a massive restructuring. I suspect and sincerely hope, that this year was a one-off. However, I can already see that HXT will soon be relatively less efficient net of the coming increased swap fees and taxes than a conventional Canadian all-cap ETF would be. Is that coming next? Only time will tell. More big distributions would be more disappointing than the Ghostbuster sequels.

Global X did have a good rationale for the changes rather than the usual active management reasons for a portfolio shuffle. I think that the addition of a small cap index makes sense. That is an important area of the market that was being missed by their previous allocations. It improves their diversification. The switch from corporate class to conventional ETFs removes some of the corporate class management risk. I suspect it will also help take some of their corporate-class ETFs generating too much income to offset expenses. Regardless, this phantom distribution is an unwanted loss of some tax deferral. With a shift to some conventional ETFs, their distributions will also have a bit more taxable income. Not likely as much as their fully conventional ETF competitors, but the gap has narrowed.