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. Eligible dividend are also taxed the year received and the rates are 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 unfavorably – 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 tax reduction.
- In a Canadian Controlled Private Corporation (CCPC), such as a professional corporation, the advantages would also be tax deferral and reduction. Further, it is a way to avoid losing the favorable small business tax rate that results from making too much adjusted aggregate investment income.
This can be done using swap-based Horizon Total Return Index Exchange Traded Funds (TRI ETFs) or Corporate Class Mutual Funds.
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. 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. Then, we can decide 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 paid 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 favorably within the bank’s structure. This seizure-inducing process is outlined in the diagram below.
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.
These ETFs are valued in Canadian Dollars (CAD). So, there can be fluctuations 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 management fee.
When buying a tradition ETF, there would be no extra currency exchange fee if it is listed on the Canadian market. 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 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 do 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. It is adjustable for province, income level, or account type for the tax drag calculations. 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 HXDM as part of my portfolio. I have no other relationship with Horizon or National Bank.