General Risks With Swap-Based ETFs – Behind The Magic Curtain

Let’s peek behind the magic curtain…

Swap-based ETFs have a number of potential benefits for an investor using a taxable account or Canadian Controlled Private Corporation (CCPC), such as a medical professional corporation, to invest. They may become particularly attractive as part of a strategy to avoid the new passive investment income tax rules if you cannot limbo under the new threshold with some simple tax lowering moves and you are one of the high income professionals who could be affected.

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In my last post, we explored the general benefits of swap based total return index (TRI) ETFs and how they work. They are basically a unique derivative structure that converts the total return (capital gain/loss plus dividend or interest income) into an unrealized capital gain/loss. This is done via a swap contract, and the only ones being done in Canada are between the Horizon fund company and National Bank.

While these products have some strongly attractive features, it is also important to understand the potential risks in making an informed decision on whether or how they could fit with your portfolio.

The three main special risks associated with the Horizon TRI ETFs are:

  • Counter-Party Risk
  • Legislative Risk
  • Specific Risk

What is the counter-party exposure risk with a swap-based ETF?

Since Horizon and National Bank have a contract to swap money with one another as the market fluctuates, one party or the other will owe money between the times that they square up the tab (usually monthly). The main risk as a Horizon investor is that National Bank cannot pay its obligations.

How big of a loss could counter-party risk cause?

The amount of money at risk would be the counter-party exposure at that time (regulated to a maximum of 10% of NAV by law, but usually less). You cannot lose all of your money from counter-party default.  Furthermore, National bank is one of the “too big to fail” banks in Canada. So, if it were to go bankrupt, there are a number of bail-in mechanisms. If that type of Financial Armageddon were to happen, your investment portfolio value isn’t going to be the currency that matters anyway. Guns, ammo, luxuries like toilette paper, and staples like a good squirrel stew recipe will be the items of value for trading at that point.


The other possible risk of the counter-party exposure in the swap-based ETF is unwanted realization of capital gains and triggering tax. If there were to be a rise to >10% in counter-party risk over a 30 day period, then the excess gain would need to be crystallized by the ETF and distributed to investors as a capital gain, triggering tax on that gain.

How likely is the counter-party risk to be an issue?

In the case of a swap-based ETF tracking assets strongly correlated with the S&P/TSX60, the risk of developing a large unpaid counter-party risk are small. If the TSX is moving up sharply, causing the amount National Bank owes to rise, it is likely that National Bank’s assets will be rising also since they are so strongly involved with the economy reflected by the TSX. It would be bizarre for National Bank to not pay its obligation promptly under those circumstances. Horizon’s ETF operational management tries to maintain a negative counter-party balance to even further minimize the risks.

This tandem movement may not be as strongly correlated in some of their foreign index tracking ETFs, but largely the world markets are very intertwined.

Overall, I personally think that the counter-party risk with these funds exists, but is small. Horizon lists the current counter-party risk for each swap-based ETF on their site. It is often negative (no risk) and I have not seen it hit 10% yet, even during some pretty remarkable stock market runs recently. I am more concerned about legislative risk.

What is the legislative risk of a swap-based ETF?

Legislative risk is that the government will change the rules and either hobble or shut-down this type of arrangement. They do not particularly like tax deferral vehicles. We have seen changes in many of those over the past decade, including Testamentary Trusts (2014), Corporate Class Fund inter-fund transfers (2016), reductions to sheltering with Permanent Life Insurance (2017), and most recently changes to passive investment income within CCPCs (2018).

This could happen to swap-based ETFs, if they grab too much of the government’s attention. If the new CCPC rules don’t raise the expected tax revenue because investors have flocked to a single asset to avoid them, then you can imagine how the government could react. Those budgets won’t balance themselves. Who woulda thought?

Update: Dec 2019. The government did launch an attack on swap ETFs. Fortunately, they have now evolved to a more conventionally acceptable corporate class structure.

How likely is legisative risk to be an issue and how bad could it be?

Your guess is as good as mine as to whether if or when swap-based ETFs could be in the cross-hairs. Given the patterns of past behaviours and pressures of future demographics, I think this is a real risk. The longer it takes to happen, the longer you could benefit from tax deferral and reduction. If it never happens, then even better.

The worst case scenario that I can think of is that they force liquidation and realization of all assets in one tax year. That would result in a large capital gain tax event that year. As an individual, that could push you up tax brackets to pay a higher marginal rate. As a corporation, that could push you out of the small business tax rate and into the arms of the Tax Pirates the following year.

small business tax Canada

What is the specific risk of a swap-based ETF?

Specific risk is the risk from owning a single financial product or asset class, as opposed to systemic risks that affect a broad range of products. You don’t get well compensated for taking on specific risk and it is mitigated by diversification – which is why diversification is central to investment risk management.

These funds are a unique niche product in Canada and only offered by a single company. So, there is specific company risk if you only use Horizon products. Fund companies can shut down, but Horizon has been around for over a decade and seems to be doing well from what I can see. I think that risk is small, but not zero.

Fund companies can also decide to close down an ETF. There are niche ETFs popping up and closing down due to poor performance or lack of interest all the time.  The Horizon swap-based ETFs for the TSX (HXT) and S&P 500 (HXS) have been around for almost 8 years, are popular, and well subscribed. S,o I think they are likely to be survivors. HBB (bonds) started in 2014 and is much smaller. In 2016,  HXX (Europe), HXQ (Nasdaq), and HXH (Cdn High Dividends) were added to the mix. HXDM (Developed Markets excluding Canada/US) was just added in 2017.

I personally find the fact that they have been expanding their stable of swap-based ETFs encouraging as to their commitment to this niche ETF model. However, I would also think that the more established large index tracking funds in their line up (like HXT with $1.7B NAV) have lower specific risk than the smaller ones (like HXE which only has a NAV of $32M).

specific risk ETF closure

All investments have risk – we must understand how they work and weigh the potential risks against the potential rewards when we make investment decisions.

This post gave a general overview of the potential risks of swap-based ETFs to weigh against the potential benefits reviewed in preceding one. How those risks and benefits fit into your individual situation will vary. To help illustrate the math, I have developed the Corporate Class Swap ETF Comparator. It is an online tool to contrast the total fee and tax drag (foreign and domestic) of the swap-based ETFs with comparable traditional ones for whatever province, income level, and account type that you want.

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


  1. Most of my corporate Canadian equity holdings are in XIC, but I do have some HXT in my personal non-registered account.

    I had been planning to leave things as they because I am an concerned about the legislative risk of HXT.

    However, I’ve started to rethink my approach (though I’ve not made any changes yet).

    I’m already over the passive income limits because of the dividends payed by XIC (and also because of dividends payed by VTI and XEM), and that will eliminate my small business deduction EVERY year going forward.

    If switch XIC to HXT, I will reduce my yearly passive income and regain my small business tax rate. If legislation changes, I will potentially have a one time large capital gain, which will eliminate my small business deduction for the next year (but only for ONE year).

    1. I am modelling that exact scenario right now. I have a very similar situation. My high level take is to have around 50k dividend income in my corp since I take enough out each year to trigger the RDTOH and get eligible dividends personally (lower personal tax and reduce tax drag in corp to zero). Above that HXT can make sense – a legislated tax event would be a one-time hit but not necessarily undo all of the extra growth leading up to that.

      1. I would be interested to see the results of your modelling of that scenario.

        My hesitancy stems from being mindful of the saying “don’t let the tax tail wag the investment dog”. Fundamentally, XIC seems to be a better investment vehicle for Canadian equity. Broader index (whole TSX vs. TSX-60 for HXT) and no counter party or legislative risk. And, the issue of loss of the small business tax rate will become a non-issue after retirement, when there will no longer be any active business income.

        On the positive side for HXT, in addition to not paying distributions, is its rock bottom MER, its structure takes away the hassle of having to manually reinvest dividends, and the lack of distributions means one less T3 tax slip to track at tax time.

        1. Absolutely agree. Investing concerns should be more the primary driver. I am taking my time thinking about it also. I guess the question (to which there is no easy answer) is how much more investment diversity/performance difference would one really gain with XIU versus HXT? There is a plateauing of risk reduction from diversification when you have >60 companies being tracked and how strongly correlated would the companies not tracked by HXT be to the TSX 60 anyway? My gut feeling is that the difference from fees and taxes (which are somewhat predictable) is larger than the potential differences in diversification or performance. My next scheduled post is about quantifying some of this with a risk premium approach. Thanks for the great thought-provoking comments as always!

  2. Still playing the calculator. What a contraption! So… would I be correct in generalizing that the difference (overall cost savings) in using swaps compared to their regular etf versions in a corporate account is rather small if you’re not having issues with you ability to have access to the small business deduction?

    Also, in the tax optimization section why would the rates be higher for taxable income than in the CCPC? Maybe this has to do with FWT that may or may not be refunded?

    And one last question.. just for clarification, would this order be correct for items to hold in a corp based on having the least tax drag
    1. Canadian equity 2. US equity 3. International equity
    And Interest is roughly somewhere between US and INT equities?

    Seems my mind is spinning:)


    1. Hi Phil!

      Yep, the risk premium for swap ETFs in a corp varies by ETF, but it really takes off if your investment income would be shrinking your small business deduction. The other time the swap ETF in a corp is way better would be if you were not paying yourself enough dividends to trigger release of your RDTOH which would then mean there is a tax drag on income in the corp. We spend enough on our lifestyle that we have no problems with that!

      Tax drag in a taxable account can be higher than a corp if you trigger the RDTOH refund in the corp making its tax drag zero or really low. The assumption there of course is that you are paying dividends to fund your lifestyle anyway – if you were paying them just to trigger your refund, then it is really just tax shifting from corp to personal. FWT is generally more fully refundable in a personal tax account than a corp where it may be only partially recoverable.

      It isn’t in this calculator, but with “The Beast” calculator that I am working on, eligible dividends are the best in a corp up until when it shrinks your SBD. The reason is not only full RDTOH refund, but also that they allow you to pay eligible dividends from your corp instead of ineligible ones – making the corp tax on dividends zero and lowering your personal tax (assuming that you would have given yourself that money for funding lifestyle). After that, US equity and international – to me it depends more on the dividend. I would take a lower dividend payer in my corp if possible. Still thinking on it. The other thing to think about with the swap ETFs is that by generating capital gains, they could help you build a nice capital dividend account to give tax-free dividends from later when OAS clawback could become important for some people. The more that I play around, the more little nuggets I unearth. It will take a while to unpack this all in bite-sized chunks I think.

      1. Ooh I didn’t think about the CDA account and OAS. Good idea.

        Thanks for the explanations. I’m starting to think since I will be in the
        first stages of adding foreign equity I could get away with the swaps and keep an eye on their growth (for gain harvesting), or when it comes down to it, vfv is very close in overal cost and no worries. It’s hard to imagine swaps efficiency continuing for 30+ years..

        I still need to work out if it’s better for international equity to be held in a personal non reg account if under the second or third tax bracket tax in AB.

        Great post, very cool calculator!

  3. Thanks for the summary, LD. Another issue for ETF is tracking error. But when I looked at these swap funds, they actually track very close to index. It’s pretty good bargain because you are converting a potential 2-3% dividend into capital gain with a 0.3% swap fee.

    With the SBD, my understanding is that even though you are paying the higher rate (27% vs. 12%) after loss of SBD, the difference when you withdrawal it personally is considerably less because of the tax integration. Haven’t worked out the numbers personally, but an example given by financial advisor showed 20% more corp tax became a 6.5% difference after corp payout.

    1. Thanks BC doc! Getting to be able to pay eligible dividends to yourself when you go over the SBD does blunt the tax bite. That does still mean paying tax now rather than having tax deferred investment growth as retained earnings. With tax integration, the total amount paid is very similar – it just isn’t deferred. I think that hits those who spend little and save alot more than those who pay out most of their earnings each year. One could take that extra money withdrawn and put in TFSAs or a taxable account. That blunts the impact further, but the taxable account has a bit more tax drag on returns than a corp account except when in the hands of a low income spouse – or using some swap ETFs.

  4. Hello LD,

    I used to think just taking out dividends from the Corp would be how we would fund our lifestyle. But now with the changes, we are planning on continuing with our salaries from the Corp instead. That way we could continue contributing to our CPP. I think either way we will be affected by the passive income threshold. And our accountant also confirmed that the difference would be small even with the loss of the SBD aside from the deferral issue.

  5. Hey LD, just wanted to check that I’m doing this right. In a corp account VFV comes out ahead of HXS by 11%, and HXDM beats VDU by 7% (where SBD is not compromised)? Is this correct?

    I was expecting a much larger difference in favor of the swaps. If so it would make the US choice an easy one. I think the problem would occur down the road when passive income would breach the SBD limit.

    1. Hi Phil. With giving enough dividend to release RDTOH and no encroachment on the SBD, I have VFV with a better tax/fee drag than HXS by 0.12%. In other words, HXS would be expected to return 0.12% less per year net (risk premium -0.12%) which sucks. The US swaps are actually worse than conventional. For HXDM, the risk premium is 0.06% which is also pathetic for taking on the risks in my opinion. I think you have it right.

  6. Hi

    Are you planning an update now that legislative risk has arrived for these products? The Liberals have followed through with their continued efforts to eliminate tax shelters, though this did not get any news coverage.

    I have some of these products in my corporate account, which is small at this point (just incorporated 2 years ago). I imagine you are aware Horizons is doing a restructuring of their ETFs. My understanding is that there are two options to exercise before the end of the year: switch the ETFs to new corporate products that have some kind of tax sheltering or do nothing and it reverts to cash (with resulting capital gains/losses). It seems to be difficult to know what to do with the information on their website. Any thoughts?

    1. Hey Dr. Chris,

      I am planning an update. I just want to see what the fees etc will be like with the restructuring. Those details aren’t out yet that I have found and they could be key. There is a good explanation of the change to corporate class structure here. It should work. However, as you say, the government seems determined to torpedo anything with a tax-advantage. That said, they have attacked corporate class before and it may be difficult to hit them further without causing disruption of how businesses are taxed on a broader scale. Doesn’t mean it won’t happen – they are kind of like bulls in a china shop.

      It is hard to know what to do, but my sense is to ride it as long as possible and continue the new structure. Of course, they may also increase capital gains taxes in the future (I think this is likely since the Liberals were looking at it and the NDP flat out want to raise the inclusion rate to 75%).

  7. Hi there,
    I’m noticing that the counterparty exposure for these funds on the Horizon’s website seems to be substantially more than 10% (e.g., currently 32.69% for HXT). Is the legislation limiting this to 10% gone now?

    1. Hi Robert. Yes these funds are no longer subject to that limitation. The upside of that is that they have been able to settle swaps at times that are good for them. They booked a bunch of losses when the pandemic hit which should give lots of runway before having to pay dividends. The risk is if National Bank goes belly up, but if that were to happen we would have huge systemic issues anyway.

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