Swap ETF Evolution To Corporate Class (Part 2: Rise of the Resistance)

Horizon’s Total Return Index (TRI) ETFs use a swap structure. That makes them very tax-efficient by tracking the total return of an index (capital gains plus interest/dividends) and only paying it all as lightly taxed capital gains when sold. Tax deferral and reduction. The complex swap structure also made them unique in Canada and very beneficial to high-income investors. A perfect target for the T2 Legislator.

Unsurprisingly, that triggered the Trudeaunator Government’s typical Gatling-gun-precision legislative response. This legislative risk was the most anticipated risk of using a swap ETF. The intent of the initial legislation was to force these ETFs to payout taxable income annually. However, the collateral damage of that legislative change potentially impacts all mutual funds and ETFs operating as trusts – as described last week.

Credit: Modified from Terminator 2: Judgment Day, TriStar Pictures, 1991.

Rise of the Resistance

Earlier this year, the tax advantages of the TRI swap ETFs looked to be terminated. However, just this month, the much anticipated Terminator Resistance was released for PS4 and XBox. Concurrently, Horizon’s human resistance mounted a response and morphed the Swap ETFs from individual “mutual fund trusts” into a group of Corporate Class ETFs. Coincidence?

Younger-me would have spent the last week blowing up cyborg assassins. Instead, older-slower-reaction-time-me spent the week wading through the nitty-gritty details of the Corporate Class ETF changes at Horizon. Some of these ETFs have an excellent risk premium for the big-savers or big-earners that must use a non-registered personal account, invest through a corporation, or income split using both (like my wife & I do). However, we wouldn’t want to take the risk of using this innovative fund structure unless it is robust and not just a stop-gap solution until the next Legislator sequel.

My immediate questions about the corporate class ETFs:

  • How does corporate class work compared to a regular ETF?
  • How well do the funds in the corporation gel together?
  • What would distributions look like and how likely are they to occur?
  • Is this just a round of Tax-Whack-A-Mole or is it robust?

I am honestly pretty excited about what I found, but you should form your own conclusions if you are considering these products.

Disclosure: We have held HXDM, HBB, and HXX in our portfolio at various times. I don’t have any at present, but I likely will again in the future. I have no other financial relationship with Horizon at the time of writing this.

What is the difference between Corporate Class and regular Mutual Fund Trusts?

Mutual Fund Trusts

Regular mutual funds and ETFs are legally “mutual fund trusts“. Each ETF is a separate fund trust. As a trust, they must distribute all income received each year to their unitholders. They use allocation to redeemer methodology to do this. This is to avoid double taxation of capital gains for investors redeeming units. The Federal Government recently made changes that will also ensure some capital gains are taxed as soon as possible for existing investors that don’t sell their units. That is logistically very difficult to implement. Hence, ETFs and mutual funds that make regular distributions have been given a one year reprieve while the potential splatter caused by this Gatling-gun approach is explored.

Mutual Fund Corporations

A mutual fund corporation side-steps this impending issue completely because it is a totally different business model and legal entity. Allocation to redeemer methodology does not apply to “Mutual Fund Corporations.” The reason is that they are not a trust, holding investments and passing income through to the trustees. They are a corporation.

Each ETF in the corporation is a different class of shares or “series”. This allows them to have different values and make different distributions. So, for the end-user, it looks basically the same as any other ETF. However, behind the scenes, they are all part of the single large corporation.

Investment income is fully taxed as business income at the General Corporate rate. Excess income can be dispensed as eligible dividends. Just like every other regular Canadian large business. Our imperfect tax integration means that the combined personal and corporate rate is higher than if the money were earned personally. Music to the taxman’s ears.

So, if poorly organized, a mutual fund corporation may not have much of a tax advantage. In fact, there is a tax inefficiency favoring the government. This makes it a less attractive target for the Trudeaunator. The key to a corporate class structure being tax efficient is how it is organized to offset investment income with expenses between its family of funds and between fiscal years. This makes understanding the details of the corporation’s business model vital.

How are Horizon’s Corporate Class ETFs organized?

The swap contract structure is maintained.

The Trudeaunator Government’s objection to the swap ETFs was the use of allocation to redeemer methodology to re-assign income to their market makers. Not the swap contracts. Swap contracts offer a number of advantages like low tracking error, lower costs for Canadian indexes, and avoidance of foreign exchange and withholding taxes on dividends for non-Canadian indexes. These synthetic ETFs are also routinely used to index some difficult to access markets like commodities. So, Horizon is keeping the synthetic swap structure.

How does the swap structure affect business income?

The value of the total return swap contract increases or decreases in size as the total return of the tracked index changes. However, the income or loss will only be realized when a swap contract is settled or partially settled. That could happen for a number of reasons.

When is a swap settled – triggering a gain (income) or a loss (expense)?

Horizon and National Bank could voluntarily settle the swap.

This is actually partially how Horizon will manage income. For example, if the swap is at a significant loss, then Horizon will settle it, book that loss, and then get a new contract. That loss can then be carried forward. So, when income is realized later, it can be offset by the previous expense to reduce or nullify taxable income. Analogous to tax-loss harvesting of capital gains by individual investors. However, an important difference is that “superficial losses” can apply to capital gains. In contrast, this is business income.

This will be helpful if a swap is forced to settle, or partially settle, at a less advantageous time.

A swap could also be forced to settle or partially settle.

One way that this could happen is if the contract is downsized. If the funds keep growing, this is avoided. However, it could easily happen if a large client redeems a big chunk of shares while the swap is in a positive marked-to-market position.

Another trigger to settle a swap would be if the counter-party exposure exceeds 10%. That could happen if there is a large market move. The most violent market movements tend to be down – which would be booked as an expense. While less common, a huge rise in an index would trigger income.

It is very likely that eventually there will be some net income in one fund or another. However, the corporate structure has another layer with which to manage that. The funds don’t exist in isolation, as they do as trusts. The income and expenses are pooled amongst the entire mutual fund corporation.

Pooling Expenses and Income: Horizon’s Secret Recipe

Through the pooling of income and expenses, the income generated from the investments can be used to pay expenses. Expenses from the higher-fee funds can also be used to offset the income from less expensive funds. A gain in one fund can be offset by a loss in another.

Of course, the obvious concern would be the balance between income and expenses. If expenses (fees) are raised to prevent net income, that would be a loser for investors. If there is excess income, then the corporation would pay tax on that. Same as losing money to a fee – except the government gets it instead. Horizon feels confident that their income and expenses will largely balance out. Being a skeptic, I pushed them on this and in the end, I think this is where things get interesting.

The TRI ETFs are baked in with the BetaPro ETFs. Some commodity ETFs are sprinkled on top. Like a loaf of bread.

I like the doughy middle of the loaf.

The TRI ETFs could generate some hefty income/gains and have reasonably low fees. This is the approach I like.

Follow an index. Rebalance only when I need to and with lazy precision. It may seem sedentary and a recipe for financial obesity. However, that is my goal. A big doughy portfolio with minimal effort.

Like the warm doughy center of a loaf of bread.

However, low-fees could spell “distributions” in a corporate structure.

The Horizon TRI swap ETFs are passive index trackers. Their fee range is competitive: 0.03% for the Canadian HXT and 0.25% for HBB (Canadian bonds). The swap structure is very cost-effective for REITs and preferred shares, making their MERs about half that of traditional ETFs. Fees for the funds covering foreign markets are slightly higher (0.30% to 0.50%). This is competitive with regular ETFs when you factor in foreign exchange and the heavy taxes on foreign dividends. The downside of this low-fee investing approach in a corporate class structure is that it is hard to offset that income with expenses.

How do corporate class mutual funds and other corporate class ETFs manage distributions?

Most corporate class mutual funds have little difficulty consuming income due to their higher active management fees. There are also some other corporate class ETFs, like from CI First Asset and Purpose Investments. The CI First Asset funds have low MERs (0.15% & 0.25%), but only cover Canadian large-cap equity (CSY) and Canadian Short-term Bonds (FGB). The Purpose Investment funds have a broader selection and a more active management approach with higher fees (0.5-1.5% range). Despite those fees, they still make regular distributions. At least the distributions are tax-efficient eligible dividends or return-of-capital.

Others like the crust.

So, for the corporate income and expenses to balance out without raising expenses, Horizon’s TRI swap ETFs are going to be bedfellows with some other funds that have significant expenses by their very nature. Their BetaPro line of ETFs and commodities ETFs.

The BetaPro ETFs are designed for active traders.

They provide daily contracts for leveraged investing (2X bull leverage), shorting the market (inverse), leveraged shorting of the market (2X bear), and a volatility index ETF.

I don’t invest this way. I mostly take the passive index investing route. However, many people do try to win at market-timing. One reason that I don’t is that I can’t tell the future precisely enough to time short-term entry and exit points well. That is vital because the contracts required to invest with leverage and shorting are an extra expense. This expense drags on performance if the ETF is held for a significant period of time.

If you can time well enough to make an outsized profit, then great! I cannot. Few can.

Commodity markets can be difficult to trade and have more fees.

This is actually one of the areas where derivative contracts are the norm. If you want to trade in this space, there will be contractual costs for doing so.

The mix of funds makes for a complimentary buffet that will appeal to different palates.

The traders using BetaPro or trading in commodities are going to incur those expenses as part of their investment plan and pay for that via their management fees. It is a cost of doing business for their strategy and these funds have an MER in 0.75%-1.5% range. Further, the inverse funds that short the market will have the fees, but not generate income from interest or dividends.

I wish the traders success in their endeavors. Mostly, I am pleased that they are potentially enabling my TRI ETF tax-reduction and deferral by allowing me to negate income without my management fees going up.

The fact that the BetaPro, within the family of funds, bet on opposite sides of the market also seems helpful. When one is generating income, the other side is generating a loss. This offsetting of gains and losses both now and on future income gives great flexibility to manage net income (and therefore distributions). For a corporate class structure to be really efficient, expenses and income need to be generated by different funds at different times.

Altogether, I think this mix of funds together into a corporate class structure is appetizing.

It addresses one of my biggest concerns (income not offset by expenses) while not really penalizing anyone with extra fees that they wouldn’t already be paying for their investment strategy. For a market to work, there must be people with different beliefs and approaches. In this case, some like the doughy center and some like the crust. To each their own, but together we are minimizing the leftovers that the tax-hounds will gobble up.

What if corporate expenses don’t offset income?

Only time will tell if the mix of funds and expenses in the corporate class will be able to avoid net income. If there is net income, then it may become necessary to distribute that. This would be less frequent and in smaller amounts than a regular ETF, but it could happen.

Any income-leftovers would be taxed at the general corporate rate. Horizon’s corporation will be domiciled in Ontario for a combined Federal/Ontario tax rate of 26.5%. This is much lower than personal tax rates. So, this amounts to tax deferral until the retained earnings are dispensed as eligible dividends. Good tax planning and management maximizes that opportunity.

Will the government simply unleash the tax hounds on Corporate Class Funds?

I honestly think that nothing is safe from a desperate government. However, I think this structure is much more resilient than the previous one.

No longer a lone wolf, but part of the pack.

The previous swap ETF fund trust structure was more complex and relied on nuances of the allocation to redeemer methodology. Horizon was the only one doing it and the benefits were mainly for highly-taxed high-income investors. Easy prey as a tax-the-rich-using-a-loophole political gesture.

Multiple companies use corporate class funds with $157 billion invested in them. That is a much tougher adversary as a pack than the ~$5 billion that the Horizon funds rolled into the corporate structure were on their own. Horizon is quick to point to this as implicit security. However, corporate class mutual funds have been on the legislative menu before.

There was a recent attack in 2017. The Federal Government legislatively ended the ability to move between different series in a corporate class fund without triggering capital gains. They are not immune. However, there are some good reasons why the government continues to tolerate the corporate class structure. These carry more weight to me.

Why I think the corporate class structure is more robust.

It is a straight forward corporation. This would make it hard to target without impacting how other financial corporations operate. Not impossible, but difficult. A major move against financial corporations would also make Canada an outlier in the world. Investment capital outside of registered accounts has wings. It would fly away. So, there would be significant collateral damage.

Plus, I don’t think there is a strong motivation to go after this structure. The reason that I say this is that the investment income is being fully taxed as income. Not, the half-rate of capital gains. Not the lower rate of eligible dividends. Income. As mentioned earlier in the article, tax integration makes this less tax-efficient than directly investing. It only becomes tax-efficient if the business is well managed. It is hard to believably spin a business that is managing its finances well as “tax-avoiding”.

Of course, collateral damage, flight-of-capital, and fuzzy political spin hasn’t stopped governments before. There are many sequels in the Legislator franchise already.

Everyone will have a different threshold for risk and reward. Will this meet yours?

Risk and reward are joined at the hip with investing. The potential reward of decreased tax drag on tax-exposed investments by using corporate class ETFs is easy to mathematically model. The risk of further legislative aggression is much more difficult to quantify. However, I will spend some upcoming posts modeling what this could look like. Brace yourself for the online Corporate Class Swap ETF vs Conventional ETF Simulator.

32 comments

  1. Another brilliant post, just skimmed over it, need to read it a few more times !
    Thanks again for doing all this legwork and communicating with Horizons. You deserve sainthood!
    Impossible to unpack the intricacies till your investigative reporting!
    Keep up the good work.

    1. Thanks Lyndon. This was a really interesting post to work on. I suspect no one else will dig into it this deeply. However, these products have some major potential for those investing in tax-exposed accounts. That includes me and I needed to know the details to feel comfortable. I previously used some of these ETFs where the risk premium was large (HBB and HXDM) where I figured it was worth the risk for us. When the legislation was first proposed, I looked at some of the other options. Neither were great: traditional corp class mutual funds (fees too high and didn’t gel with my investing approach) and the European non-distributing synthetic funds (tax complexity/risk). After dissecting this restructuring and the legislative issues, I am both relieved and my interest is rekindled.
      -LD

  2. Thanks for this detailed explanation. Sold out of HBB when the last budget was announced. Held on to HXT and HXS (due to large capital gain situation). Will sign the documents on the Horizons website to convert to this Corporate Class structure for the existing holdings but not going to add to positions for a while yet. HXS and HXDM are most appealing due to re-characterization of foreign income to capital gains, and HBB for re-characterization of interest income to capital gains. For those approaching a drawdown (retirement), the utility of these funds is lower as one will need the income thrown off by the conventional versions of these ETFs anyway.

    1. Hey Ticdoc. I am updating an online tool to directly compare these ETFs to their traditional counterparts. HXDM and HBB are my top choices also.

      I actually think that their utility is unchanged in retirement. One needs regular income, but that doesn’t need to be interest and dividends per se. You would want a mix of assets that dampens volatility as drawdown is approached and in the first years afterwards to minimize sequence of returns risk. That generally means bonds, but HBB would do that. In fact, it is more tax efficient to take capital gains for income as needed. It is also more flexible to smooth income than regular interest/dividends where you get them regularly without control. This becomes really important if you have a large corporate portfolio where income requires you to dispense more dividends to release the RDTOH. That could mean taking more out than you need or leaving RDTOH trapped in the corp. I have actually been thinking about this a lot lately as we will be transitioning from pure accumulation to some reliance on my wife’s investment income (to income split) over the next couple of years as I scale back further.
      -LD

      1. When you build your calculator, take a look at ZDB (discount bonds) in corporate accounts. Just as tax efficient as HBB but without the complex contortions and risk of future Tax Act changes- Justin Bender did a comparison of HBB and ZDB in his blog a while back.
        I too Like BRK.B as a US investment. Replicates the total return of the index over a 10 year holding period and no dividends to worry about so no annual taxes. Jus capital gains taxes when you sell. (of course the inclusion rate on capital gains is subject to change at the whim of the Govt.)

        1. Hi Ticdoc,

          Actually HBB is more tax-efficient than ZDB. Justin Bender’s estimate was 0.22%/yr. I actually modeled it over different time periods, including a legislative attack for a taxable account and a corporate account last spring. It will be repeated with the most recent numbers in the calculator. The efficiency varies by income level and account type, but HBB comes out ahead. Also, while moderate duration bonds can have some capital gains/losses, they are of a small magnitude compared to equities. So, the impact of a forced capital gains realization is generally less than the annual tax savings.

          I also think the capital gains inclusion rate is a potentially important variable and will make it adjustable in the upcoming simulator.
          -LD

  3. Thank you for the great analysis. I sold my Horizon HXS ETF when the budget changes were announced, but now I will take a second look. I remember reading somewhere on your site (comments?) that HXS is not the most tax efficient or cheapest way to invest in the S&P in a corporate portfolio, but I can not find the reference. What are your thoughts on this right now ? What US ETF did you chose for yourself?

    With all the changes thrown around at us, I just gave up and constructed my own index with individual securities, a ghost ship portfolio if you want, but I know this is not optimal for the US holdings tax wise. It works beautiffully for Canada though and I have been getting index-like results or better since close to 5 years now.

    Mai

    1. Hey Mai. I am actually right in the middle of re-looking at the tax-efficiency of HXS and others. It is a mix of fees, FWT, corp tax, and personal tax that I am building into an online simulator for all of the swap ETFs vs a traditional comparator. I am currently using a complex solution (QQQ and BRK.B in my corp, IUSV and IJS in my RRSP). HXS may be simpler and better than my QQQ/BrkB in my corp solution. Stay tuned.
      -LD

  4. Thanks for your efforts with the research and this website.

    So to clarify and confirm for me – these funds, e.g., HXS, HBB, are a good option for a CCPC investment account? I’m coming up against the $50,000 passive income threshold that’ll affect my CCPC’s small business rate in the near future. Am I right to be looking for low distribution investment options, which these Horizons TRI funds would be, as they have no taxable passive income distribution until I sell the shares in the future? Are there any other competitive low- or no-distribution investment options out there for a CCPC in this situation?

    Thanks again.

    1. Hey MD.
      I think that makes good sense to me if you are looking to keep working/earning/spending the same. I decided to work less and lower my active income, but that has been a recent decision. I built my portfolio with the plan of minimizing the passive income issue while continuing to work hard. Keeping income out of the corp is key (having built a large RRSP and TFSA to put the big income-producers helps).

      There are pretty limited options. The option that I use is to split my US funds to use some QQQ (<1% dividend) and maybe some Brk.B (no dividend) in the corp and I have IUSV and IJS in our RRSPs or my wife's account - but that is less diversification and more complicated. The main dividends in my corp come from Canadian dividend-paying ETFs. I touched on the other corp class ETFs from other companies in the post, but they are also limited (Canadian bonds and Canadian market) with higher fees and more probability of distributions than the Horizon products. I also looked at some non-distributing synthetic ETFs on the Irish stock exchange, but that would have been really complicated and may still have some tax issues. I personally think that the Horizon TRI funds are the best option and now with the corporate class change to put them on more solid ground, I am considering some changes to use them more. Even without hitting the passive income limit, the ability to control my income better with the corp class swap ETFs is very attractive.
      -LD

      1. Beautiful, thanks so much for taking the time to reply.

        If I may ask a couple of more noob questions: I would be planning to make lump-sum purchases of these Horizons TRI funds a few times a year; is it pretty straightforward to keep track of adjusted cost base for that? What tool do you recommend for doing so? I haven’t really invested in ETFs in my CCPC account before, and am wondering how to best track ACB’s and provide the info to my accountant.

        Thanks again.

        1. Hey MD,
          Honestly, I just keep my transaction records and account statements from my MD Direct/qtrade account and give them to our accountant. I used to give him an excel spreadsheet, but he always redid it all anyway.
          -LD

        2. @MD I would recommend Adjusted Cost Base.ca for tracking ACB. They seem to have all the transactions you could ever run into including those originating from the fund side. Just be sure to download an Excel copy of your work just in case they ever go under.

          I own Horizons TRI funds and tracking the ACB is quite straightforward as you rarely get fund initiated transactions (e.g. return of capital, etc.) that will affect your ACB. Having said that, it’s always a good idea to eyeball the CDS Innovations database after each year and check what your fund did.

  5. These are great pieces, providing a much clearer and more detailed analysis of the promise and perils of the new corporate class structure than I have found anywhere else. And much more entertaining!

    We own several of the index-tracker ETFs in corporate as well as taxable individual accounts. One niggling concern that I have relates to the fact that there are theoretical scenarios where losses and liabilities of one or more of the ETF classes (i.e. the Beta Pro ETFs) could have a direct, adverse impact on the NAV and market value of other ETF classes (i.e. the index trackers). The theoretical risk is acknowledged in the following extract, from the Horizons ETF Corp. prospectus dated November 15, 2019 (top of page 40):
    “Each class and series of the Company has its own fees and expenses which are tracked separately. Those fees and expenses will be deducted in calculating the NAV of that class or series, thereby reducing the NAVof the relevant class or series. The liabilities of each class of shares of a Company are liabilities of the Company as a whole. If one class or series is unable to pay its expenses or liabilities, the Company is legally responsible to pay those expenses and as a result, the NAV of the other classes or series may also be reduced. Similarly, if the liabilities of a class of shares of the Company are greater than its assets, the other classes of shares of the Company may be responsible for those liabilities.”

    This passage appears in the “Risk Factors” section of the prospectus, which of course includes every conceivable risk, no matter how probable or remote. What I’m wondering is whether the risk of classes of index-tracking ETFs being left holding the bag for losses incurred by one or more of the more of the more speculative ETF classes is realistic enough to be concerned about. I don’t really have a sense of whether it’s realistic to suppose that one of the speculative classes of ETF could suffer losses that couldn’t be covered internally, and so would have to be covered by other classes. I’d be interested in your thoughts on that subject?

    Thanks again for your great work.

    1. Hey Rick. Thanks for the great addition to the conversation. This kind of critical thinking and skepticism is healthy when examining products. It is also what I am tossing around too and thanks for posting. That description of company responsibility for liabilities would describe any corp class family. I actually think that the Beta Pro should generally work out because a liability for the bear version and bull version will move in opposite directions. There will be winners or losers for investors picking a side, but the company should have a neutral position. Minus the costs of the contracts which the higher fees extracted from the NAV of those products should cover. On the indexing side, if one market was decimated while the others were not, I could see an impact. That is unlikely amongst the equities or preferred shares ETFs because global markets are so interconnected. I think they’d all sink together. Bonds are pretty stable, so I can’t imagine decimation there. The volatility tracking ETF is going to erode over time due to the cost of the contracts (which is predictable). It could have a spike up, but volatility doesn’t usually spike down. So, while a theoretical risk for any corporate family of funds, I actually think the risk of that is low with this set-up. I would be more concerned if there were a small number of funds (to manage across) or some unbalanced leveraged funds (only bear or only bull). Does that make sense?
      -LD

  6. Thanks for your reply, which does indeed make sense.

    I do have one follow-on observation, upon which you might want to comment. Suppose that “Fernando” and “Yogi” are the bull and bear versions of a particular leveraged Beta Pro ETF (i.e. share class). Suppose also that as the result of some extraordinary market events over a short period of time, Fernando does exceptionally well but Yogi does exceptionally poorly. Let’s say that before these events each of them had a net asset value of $10 million. As a result of the events, Fernando’s NAV shoots up by $20 million to $30 million, but poor old Yogi’s NAV declines by $20 million to negative $10 million: i.e. Yogi has incurred a liability of $10 million that cannot be discharged out of its assets [I’m admittedly not sure it is realistic to envision Yogi suffering such severe losses as to get into a negative NAV situation, but let’s assume that it is.]
    As you point out, at a corporate level the losses of Yogi are exactly offset by the gains of Fernando. However, while Fernando’s entire $20 million gain accrues to its unit holders, I suspect there is no mechanism for making a cash call on Yogi’s unit holders to make up the $10 million shortfall in Yogi’s assets. Presumably then, the $10 million cost of discharging Yogi’s net liability would be allocated in some fashion to all share classes. If so, then investors in share classes other than Fernando and Yogi would be bearing part of the risk of the strategies followed by investors in Fernando and Yogi. Of course, this would only be a concern to the extent that there is a realistic possibility of Yogi (or any other share class) getting into a negative NAV situation.

    Cheers,
    Rick

    1. After thinking about this, the only way that I could see the liabilities of one ETF impacting another is if the NAV of the losing ETF went below zero. However, the way that the inverse and leveraged ETFs contracts are designed is that they move as percentage basis. Not dollar for dollar. That way they cannot actually go below zero. I found this article which explains why a leveraged or inverse ETF cannot go below zero. Thanks for the great point – you stretched my brain and I learned something!
      -LD

      1. Thanks for your further analysis. I missed your reply of Jan 15 when you first posted it. I have just read the article you referenced, which I found very interesting. It’s reassuring (at least for someone investing in the index trackers that are part of the same corporate structure) to know that the inverse / leveraged ETFs’ asset value cannot become negative. I must say that reading the article certainly did not inspire me to rush out and start buying inverse/leveraged ETFs!
        Cheers,
        Rick

  7. Thank you for the detailed insight into a complex topic. I wondered at the utility of these funds in a personal corporation that is quite young? As someone who is 2 years into their practice and just trying to set up a good foundation for my corp, my research to date has suggested passively mirroring the market with a portfolio similar to VCN + VXC/XAW + VAB is a very reasonable tactic. I personally don’t have any VAB currently because I’m using my mortgage as a bond equivalent.

    You’ve proposed a very interesting product that I expect would suit my corporation well in the future but what about now? I’m a few years away from reaching the passive income limit. Until that limit is reached would I be better off staying with VCN/VXC or are there benefits to getting into the HXT/HXS products and staying there long term?

    As a side note do you feel Horizons use of mirroring the S+P is a reasonable substitute for the full market mirroring of the vanguard products?

    1. Hey Cog. Passive index investing is the way to go in my opinion.

      Regarding now vs the future is an interesting question. There are several dimensions.
      1) If going to hit the passive income limit while quite young and likely to continue earning and investing for a long time, then using something like a corp class ETF sooner rather than later may be helpful. The reason is that it would delay hitting the passive income limit and then slow its shrinking. If waiting until it is hit, they can still slow the loss of the SBD, but not halt it. It will continue to shrink as the dividends of the pre-existing investments continue to grow.
      2) Income in a corp can cause a second problem. You need to be giving dividends to yourself to release the withheld RDTOH. If not, that is a >30% tax drag. This is not an issue if you are spending a lot and therefore giving yourself a bunch of dividends anyway. However, for the person who is not spending much, salary to get RRSP room and then keeping as much in the corp as possible may be better.
      3) Eligible dividends flow nicely through a corp. If I used VCN in my corp and some corp class ETFs for my foreign markets and bonds, then I could have much more VCN before getting into passive income problems.

      Regarding S&P 500 vs broader market. If using conventional ETFs, the broader US market includes some mid and small-cap which historically have boosted returns slightly over long time periods. That premium may be lower moving forward for a bunch of reasons, but no one really knows. What I am doing personally is using HXS (S&P500 corp class) in my corp and some US small-cap-value (IJS) in our RRSP or personal account. That is a bit more complicated and there is something to be said for keeping it simple.
      -LD

      1. Thanks for the reply.

        Currently I take a salary that is slightly higher than required to achieve max RRSP contribution. I do not take any dividends. The goal has been to leave as much in the corporation as possible.

        If I interpret your response correctly, this might end up being superior? Also, under this scenario the tax benefit of a corp class ETF would be eliminated as I’m not taking dividends? Therefore invest in a non-corp class such as VCN etc?

        My confusion comes in that would this not be the situation with the most benefit from corp class? If I’m leaving the lion share in the corporation then corporate investment income will be higher and I’m more likely to approach the passive income limit? I presume it would never worth it to take a dividend and remove money from the corp just to decrease the tax drag of a corp class ETF?

    2. @Cog For HXS, I personally use Vanguard’s VXF in order to capture the entire US market. Problem is I have to balance them in a 4:1 ratio which, as TLD pointed out, is not simple and adds to my portfolio workload.

      FYI, Horizons has just released HXCN which offers better coverage of the Canadian market (95%) than HXT (TSX60 only) – worth looking into.

  8. Excellent info! I really appreciate this blog! Horizons just released HXCN and HULC. Would you rather use HXCN due to broader coverage or should I just stick with HXT? Also, any insight into HULC? I don’t really understand its role over HXS and why horizons would introduce it. If it has no distributions it seems like it is just like HXS, except without the 0.3% swap fee, but with a ~0.3% foreign withholding tax.

    1. @Abdoc John Bogle once said that with index investing instead of looking for the needle you buy the entire haystack. So, if you take his advice to heart, it just makes sense to invest in the entire market rather than just a specific segment. To choose specific segments in the belief that you can get better performance is not something a passive investor would do. But there are investors out there who try and that is why funds like HULC exist.

      Your post implies that you are already invested in HXT. If so, bear in mind that selling HXT just to buy HXCN will likely trigger capital gains (the TSX has done well recently) and a tax bill. To avoid the tax bill consider buying iShares XMD – the combination of HXT/XMD in a 3:1 ratio will give you the entire Canadian market. Unfortunately, this creates more work for you going forward as you’ll have to manage 2 funds and keep them in balance. Plus, XMD is a traditional Cdn equity ETF so it will throw off taxable dividends and gains.

      Mind you, triggering capital gains isn’t necessarily a bad thing. In fact, I’m crystallizing all my capital gains by liquidating my entire MPC portfolio so I can issue a capital dividend to my wife. A side benefit of this is a clean slate and I can stop bothering with HXT/XMD and use HXCN exclusively. I just hope the rumours about a hike in the capital gains inclusion rate in this year’s Federal budget won’t come true….

    2. Hi Abdoc. For HXCN – it adds a bit more diversification compared to HXT by adding in some smaller companies than the TSX60. Not sure that I’d sell and switch (unless part of my overall plan) but could be better moving forward. Historically the TSX 60 has outperformed the broader Canadian market but no in knows if that will continue or not. HULC is interesting – I am thinking about it. The MER is lower without the swap and that also makes it less complex. The fund would pay 15% FWT but I wonder if any of that is reclaimable by the fund corporation. The other question is whether it will make distributions. They say not, but it isn’t as easily controlled as a swap is. Need to think on it more and investigate.
      -LD

  9. Thanks LD, your website is excellent and such a valuable resource for MD’s. Our family is indebted to you for your advice.

    Anyway I just wanted to chime in on these swap ETF’s. As you have warned the tax issue is not completely resolved. I was just listening to BNN : https://www.bnnbloomberg.ca/etfs/video/john-hood-discusses-the-hxt-and-hxs~1323724
    And the guest John Hood stated as much.

    I know the track record of the CRA oh so well and with “More ‘No'” and the Trudeaunator scrounging around for every last nickel and dime, I’m afraid that the CRA will likely go after these swaps as well.
    But of course to generate maximum revenue, the CRA will stay silent for a couple of years and then retroactively impose arrears, interest charges, late fees and failure to pay fees on the people who continue to buy these swaps.

    I’d stick with the QQQ, Brk.B, SPY, DIA in the Corp account as you are doing.

    1. Thanks for passing this along Monterey. I agree that anything that is a bit out of the mainstream and delays or is even perceived to delay/reduce tax will be on their radar. Having viewed the clip, I don’t think this guy is adding any new info about the swap ETFs per se. He brings up issues with leveraged ETFs and inverse-ETFs in general. I think the corp class structure is pretty robust. The swap usage is still a potential legislative vulnerability in my opinion. I don’t think they’d be able to retro-actively ding people on these other than forcing a realization of capital gains. That to me is the biggest threat. However, with the last legislative attack and looking at some others, the most likely result of a legislative maneuver would be to force regular distributions moving forward (who knows – I don’t put anything past them either). That would still be more efficient in a corp class structure than regular – although not as good as the swap/corp class combo. As with all investing, I think that there is a potential reward and risk with all of these products. Some have a better risk-reward balance than others (why I made the Corp Class ETF Comparator to give some sense of potential benefits). In general, the US tracking swap ETFs are a bit less beneficial (I have used a combo of QQQ and Brk.B as an alternative also!). Their new HULC.TO etf I find interesting – it is corp class but holds US stocks directly rather than as a swap. Low MER, low potential distributions, and basically tracks the SP500. Plus it sounds like HULK!
      -LD

  10. Thank you so much Dr. Loonie,

    If you are able to find a bit of spare time, could you please consider adding HXEM (Horizons Emerging Markets Equity Index) to the Corporate Class Swap ETF Comparator?

    Thanks again!

    1. Thanks David. I will do that when I circle back. This is good news. I actually chatted with some of the Horizon folks back in ?January and mentioned the missing piece of their suite was emerging markets. They thought it would be hard to cost effectively do, but looks like they found a way. I will also add in HULC which is a more cost effective way to cover US large cap than HXS.
      -LD

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