Swap-Based ETFs – Quantifying The Risk Reward Relationship

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.

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.