General Risks With Swap-Based ETFs – 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.

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.

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).

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.