Swap-Based ETFs – Quantifying The Risk Reward Relationship

investment risk premium

Quantifying Investment Risk

Risk is sometimes predictable and easy to quantify. Those of us who were allowed to play unsupervised as kids learned how to do that through experience. The lane-way behind my childhood home was the scene for many acts, such as the one above, being recreated by a crack stunt crew of adults.

As an adult, I have become adept at predicting the outcome of some risky situations – like that a trip to the emergency department will usually follow the words “Here. Hold my beer and watch this…” Quantifying other risks, like the usage of swap-based ETFs in my portfolio, are more of a work in progress.

Horizon’s swap-based ETFs or Total Return Index (TRI) ETFs are a niche product that magically convert investment income into unrealized capital gains. The biggest appeal of that financial wizardry is tax reduction by changing full immediate taxation to deferred taxation at half the rate (or even less if you have a lower income when you start cashing in for retirement). Reducing that drag of taxes on a portfolio can have massive effects over time. Unfortunately, the swap magic can carry risks and we need to weigh the risks of swap-based ETFs against the benefits.

We want to make sure that we take well compensated risks.

In all of investing, risk and reward are related. If something is risky, then it needs to have a potential for greater reward to entice investors to support it. While risk and reward are related, it is not a perfect relationship. Some risks are well compensated with increased rewards and others are not well compensated. For example, in my investment risk primer, I mentioned that the specific risk of investing in a single company is often not a well compensated risk compared to diversifying by investing in many.  To make better decisions about risk, we need to quantify that risk as well as we can to make sure that we take well compensated risks.

The risk premium helps us to quantify how well a risk is compensated.

One way to think of how a risk is compensated is the risk premium. That would be how much increased return on your investment you would get for taking the risk compared to a safer investment. For example, a riskier corporate bond may pay 7% interest compared to the 3% interest of a safer government bond. That would be a risk premium of 4%. It is an objective number.

Whether that risk premium is worth the risk is more subjective, based on how likely a bad event is to happen (a guess), and how bad it would be if it did happen. An investment with a high chance of a bad outcome (like debt default) and a catastrophic result (losing all your investment money) had better have a phenomenal risk premium to be worth it. If you think of your money as little workers going off to make you more money, then this would be the hazard pay.

For swap-based ETFs, I will attempt to quantify risk by determining:

  • The risk premium for a given swap-based ETF compared to a “matched” traditional ETF peer.
  • The tax and growth impact that legislative risk could have on a portfolio using swap-based ETFs at different time points in the future.

The formula for determining the swap ETF risk premium that I will use:


In determining the risk premium for the different swap ETFs, the management and swap fees are pretty straight forward to find and calculate. However, there are a few more complexities to consider:

  • Foreign Exchange. The foreign index ETFs have a higher swap fee which is a drag on annual returns. However, buying a foreign ETF would also have a one time exchange rate charge. That is not captured in this calculation, but would be 0.5-1% at the time of purchase. This would be included already in the management expense ratio of a domestic ETF that tracks a foreign index. So, I will use domestic ETFs where possible for a fair comparison.
  • Taxes. This is where it gets complicated and there is large variability in the risk premium for a given swap-based ETF. In a taxable account, the income of the account holder (both from working and investing) makes a difference. In a corporate account,  the active income level, passive income level, and how much eligible and ineligible dividend income is dispensed to trigger refund of the RDTOH all make a difference.

Let’s not let complexity scare us off. We can make it simple.

A few rules of thumb:

  • For a taxable account, the higher your tax rate, the better the risk premium.
  • When using a corporate account, if you are in a situation where more passive investment income shrinks your small business tax deduction, the risk premium improves substantially.
  • If you pay yourself enough dividends each year to trigger refund of your RDTOH from your corporate account, then the risk premium for using a swap-based ETF is reduced. This is because dividend income can be passed to an individual very tax efficiently via a corporation in this situation.

I have made an online swap ETF comparison simulator to do the math to compare the corporate class swap-based ETFs to matched conventional ETFs.

weighing investment risk
The underappreciated hazards of an RV vacation at Disney in Florida.

Of course, in addition to the risk premium that we get paid when things go well, we also need to consider the potential consequences of being forced to realize capital gains due to a legislative attack on swap-based ETFs. That will depend on the number of years of growth before a tax attack, the size of the capital gain at that point, and the tax rate triggered by it.

The best way for us to compare the potential risks and rewards for a specific swap-ETF in a specific situation will be with some case studies.

Next week we will start exploring the nuances of the risk premium and potential hazard of swap-based ETFs in The Sim Lab. We will start with a look at HBB (the Horizon Canadian Bonds TRI ETF) as a way of holding bonds in a taxable account compared to a conventional bond ETF or guaranteed investment certificate (GIC) as our warm-up. Getting limbered up will be important, so that we don’t pull something when we take on the more complex situation of HBB in a corporate account.

If you can’t contain your excitement, you try my swap ETF risk premium calculator to play with it. That usually works to dampened my wife’s excitement. We will use the calculator as a baseline for the financial simulations, but will also delve way deeper with a look at longer-term possible outcomes.


  1. Hi Dr. MB! I am still going by Loonie Doctor, but changed my search engine identity to make it easier for people to find if just Googlin’. I really liked your recent simplifying finance post. The swap ETF vs bond fund vs GIC is interesting. I am going post it in two parts because there are some neatsl intricacies. Nothing wrong with going halfsies – no regrets and better diversification!

  2. Hi Mark, thank you for this comprehensive review on swap-ETF!
    I am a young medical specialist in the province of Quebec. I have filled my RRSP and TFSA space, I am starting to accumulate in my professional corporation but I am still far from the passive investment income limit. Before reading your article, I thought that the swap ETF would be a great option.
    However, after playing with the numbers in your ETF comparator, I conclude that the risk premium for a young professional who does not yet have the passive placement limit is not as good as I hoped! I arrive at a premium risk for HXT at + 0.15%, HXS at -0.11%, HXDM at + 0.07%. Only HBB seems worth it. Do you come to the same conclusion for swap-ETFs held in a corporation still far from reaching the passive income limit?
    Thanks again

    1. Hi Mathieu,

      Personally, I have found the same. HBB is worth it in my mind – I wrote about it here.

      HXT may or may not be worth it in a corp because using a regular ETF for Canada gives you the ability to use eligible dividends to reduce your tax bill while HXT does not. That is why it has a negative risk premium. That could be a different story in a personal account in the provinces with high eligible dividend tax rates. Especially if you don’t need many dividends to live off of. In a corp that will hit the threshold, it may be useful. Lots of variables.

      We have found HXDM worth it in my wife’s personal account since the dividend is so huge for the traditional ETFs covering non-NA developed and she is in a pretty high tax bracket now. The fees on regular US ETFs are so low and their dividends also are low that to use the swaps in a corp below the threshold is debatable.

      The other question that I have pondered is using swaps prior to hitting the threshold to delay hitting it down the road. If I were predicted to hit the threshold at a young age and determined to continue working full-time beyond that, then delaying the tax bump proactively is an interesting idea. The game changes completely as you approach the passive income limit for a corp. Bringing down passive income can become key in that situation. Now, in Quebec, there is another wrinkle. Passive income may not matter to many PQ docs since they don’t get the small business deduction rate anyway (you need 3 or more employees to get it) – so they have nothing to lose.

      1. Thank LD for the quick reply.
        For PQ docs that don’t get the small business deduction rate anyway you wrote ”they have nothing to lose”; my analysis is that the risk premium for swap-ETFs may be higher with that fact. Am I correct? Does your swap-ETF comparator take this into account?

        1. Hi Mathieu. I didn’t consider it and I think you are right. I can see how that would happen. For example, if you have non-Canadian investment income, it will force you to give out ineligible dividends (at a higher tax rate) instead of eligible ones – even though you have earned GRIP from paying the higher corporate tax rate. That is a big blow.

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