Corporate class funds have been around for a long time. The main advantage of corporate class funds is to avoid taxable income and generate capital gains instead. However, their popularity has waned and many funds have been winding down. That is often due to fee compression and the generation of net income to distribute. In contrast, Horizons ETFs switched to a corporate class structure a few years ago in response to a legislative attack on their swap ETFs.
The Horizon corporate class ETF family structure is well-designed. They have low enough fees to be attractive for their potential tax benefits. They are now less susceptible to legislative attacks, but the risk of managing income still exists. Learn more about the corporate class structure and how Horizon is doing with that after several years of real-world experience. Will they buck the trend through their innovative design? Or is there trouble on the horizon?
Disclosure: I use the Horizon total return index tracking corporate class ETFs in my various tax-exposed accounts. For me, the tax benefits (net of fees ) are worth the risks. I plan to continue using them, but I am also aware of the potential risks and monitor them. You must judge for yourself and make your own decisions. Further, I have no business relationship with Horizon at the time of writing this. I will present publicly available data, but also my opinions and understanding as a finance nerd. Not a financial professional with knowledge of the inner workings of Horizon. I can make no specific recommendations.
Conventional vs Corporate Class ETF Structure
Mutual Fund Trust Income
Conventional ETFs have a mutual fund trust structure. That means that each individual ETF has to distribute whatever investment income it receives, net of expenses. The management expenses and trading costs are used to offset the less efficient income, like interest or dividends, and the leftovers are paid out. Net capital gains from rebalancing or holdings turnover are also distributed in the year incurred.
Mutual Fund Corporation Income
With corporate class ETFs, each ETF is a class of shares in the larger mutual fund corporation. Different share classes allow each ETF to be assigned a different value or make different distributions. However, the income for the corporation is net across all of the different ETFs. So, the income from one ETF can be offset by the management expenses or losses of another ETF. Losses can also be carried forward to be applied against future income. If the net income is zero, then there is no corporate tax. That also means no dividend distribution. So, no taxable income for the investor either.
As the holdings allocated to each ETF grow, the net asset value (NAV) of the corresponding share class grows also. The ETFs that have more management costs would have that deducted from the value of their shares. No one has a disadvantage worse than the costs they would normally incur. When the shares are sold, the growth in their value is taxable at the favorable rate of a capital gain.
Swap Contracts: Horizons’ Special Ingredient
Horizon was pretty clever in designing their corporate class ETF suite to take advantage of how mutual fund corporations work. The underlying indexes are still tracked using swap contracts. A swap is a derivative where Horizon holds cash for collateral and they have a contract with a bank that invests in the index.
The bank holds the stocks or bonds and collects the dividends or interest. Banks are able to handle that tax efficiently. When the swap contract is settled, the bank pays Horizon the increase in value of the underlying stocks plus their income. If the total return (capital gains plus income) of the underlying index has been negative, then Horizon pays the bank the difference. It is a nebulous structure, but there are three practical effects.
Strategically settling contracts.
A major advantage is that Horizon can strategically decide when to settle contracts to book losses or delay taking income. That helps with managing income for the mutual fund corporation. For example, they settled contracts and booked massive losses during the Covid-Crash of 2020. Those can be carried forward to offset future income.
Settling swaps to manage counter-party risk.
If the unsettled swap has a lot of money owing to Horizon, then there is some counter-party risk. That is because if the bank were to go bankrupt, it could default on payment. This shows up as a positive number in the products section of their site.
Previously, counter-party risk was limited by law to 10%. However, that limitation no longer applies to the mutual fund corporation. For example, HXE currently has 59% counterparty risk as I write this. In contrast, slower-moving funds (like the bonds HBB fund) only have a counter-party exposure of 0.35%. Still, Horizon has had to settle some swap contracts and take income to be prudent at managing the potential risk. For example, that happened when the markets took off like a rocket post-Covid and the counter-party exposure became huge.
Derivative income is business income.
The third practical implication is that the income generated from settling swap contracts is considered regular income. Not dividends, capital gains, or interest – even though some of the total return of the underlying indexes was due to a mix of those different income types. That is an advantage for foreign dividend income because it avoids foreign withholding taxes. However, what would normally be tax-favored capital gains and eligible dividends are taxed more as regular income.
In summary, the swap structure offers the advantage of better control over realizing income in the mutual fund corporation. However, if there is income – it is more highly taxed. More on this later.
The ETF Mix In Horizon’s Mutual Fund Corporation
Another way that Horizon was clever in designing its corporate class ETF family is the mix of funds.
They have a mix of passive total return index (TRI) funds and expensive boutique funds. The passive TRI funds have low costs (0.03-0.5%/yr) and would be expected to grow and likely generate income over the long run.
Some of the ETFs, like HXQ and HULC, hold underlying securities that will pay dividends regularly.
The potential derivative income from swap settlements and growing regular dividend income could present a problem since they want to keep the net corporate income zero. They need growing expenses to offset the income.
Fortunately, the boutique BetaPro funds come with lots of expenses and are geared towards active traders. They use daily contracts for leverage, short-selling, and management in niche sectors. Those expenses make those funds like money pits, with management and trading costs in the 1-3.5%/yr range. Bad for the speculative investors that use them, but a normal cost of trading using those strategies. Good to offset the income of the TRI investors.
Horizons Fund Corporation’s Net Income
That money sump is an advantage that other corporate class fund families have not had. Well, other than more expensive active management costs for all of their funds. However, if the growth of index investing rapidly outpaces the usage of the more costly boutique funds, then the income could eventually overwhelm the expenses. The passive index-tracking ETFs are already about 90% of the assets in the corporation. Horizon seems to recognize this threat and has been adapting.
I think not. However, this section is just me speculating and management-splaining.
Horizon’s asset allocation ETFs all currently use the efficient TRI ETFs. Asset allocation ETFs are being recognized as a great way to invest. Their popularity would also increase the pace of potential income growth as they buy more of the underlying corporate class TRI ETFs. Recently, Horizon changed their AAETFs to allow them to hold conventional ETFs that pay distributions. That could defray some of the problem. Or maybe not. If new money flows into the swap ETFs are faster than market growth, then purchasing new swap contracts could lower the counter-party risk and the potential need to settle old ones.
Horizon also suspended new subscriptions to their HSAV ETF which has a high-income yield. Presumably, to help limit the income generation in their mutual fund corporation from this type of investing. They now have CASH as a high-interest ETF outside of their corporate class structure instead. Notably, HSAV is not swap-based. So, it receives interest payments at a current yield of 5.5%. The interest income has already jumped from ~$11 million in all of 2022 to $52 million in just the first half of 2023. Removing it from the corporate class to a conventional ETF would not be popular with its unit holders, but might help the corporation as a whole if interest rates stay elevated.
The Sum Of The Parts
If or when income could outstrip the expenses of the mutual fund corp is not predictable. This is because the most of the actual income is only realized when swaps are settled, and swaps dominate the holdings. There are also losses that can be strategically harvested and carried forward. Risk management fits into that decision and is also impacted by market performance. Horizons does receive some regular dividends and interest income. While they cannot control that, it is a small amount overall.
Those are a lot of unpredictable moving parts. However, we can see how that is playing out overall by looking at Horizon’s mutual fund corporation’s net income or loss pool over time.
Horizons Non-Capital Income Loss Pool
At the end of the annual report for funds in the corporate class family is a section called “Notes To Consolidated Financial Statements”. In section 12, there is a listing of non-capital losses carried forward. That is the loss pool that Horizon has as a buffer against income. The sum is shown for each year in the chart below.
So, you can see that Horizon got off to a great start with building a $4 billion dollar buffer. They booked massive losses by settling swap contracts during the Covid-19 market bottom in 2020. Since then, there has been income exceeding expenses each year. You can see that by the loss pool shrinking. Probably due to growth in the TRI ETFs and settling swaps to manage counter-exposure risks prudently as markets went on a tear to the upside. Even though markets pulled back again in 2022, they were not able to grow their loss pool that year.
Horizons Corp Class ETF Loss Pool Burn Rate
The “burn rate” of that buffer is another way to look at it. In the chart below, I show the same data as the annual change in the loss pool. At the post-pandemic burn rate, the loss pool would be exhausted and taxable income generated in about five years. If the markets take off like a rocket, that burn rate could increase to keep counter-party risk in check. If Horizon finds opportunities to harvest some losses, opens popular expensive funds, or can manage swap settlement really well – then the burn rate could slow.
It is also important to put the burn rate into perspective. For the last two years, it has been about $550 million dollars per year. The assets in Horizon’s mutual fund corporation were $25.25 billion dollars at the time of writing this. So, if Horizon used up its loss pool and continued to generate $550 million/yr in net income. That would represent a 2.18%/yr net income yield.
What happens if there is net income in Horizons ETF corporation?
Net income would be subject to taxation within the corporation as a whole. How that burden would be assigned to each ETF share class is uncertain. There are also features of corporate taxation for mutual fund corporations and derivatives that make it potentially nasty. With the exception of having high-interest savings account ETFs in their corporate class structure, I think that Horizon has built it pretty well. I plan to stay on board. The current ride is too luxurious from a tax efficiency standpoint and there looks to be open seas ahead for now. However, I am going to keep my eye on the horizon and know where the lifeboats are.
There looks to be some time away, but the current loss pool burn rate shows that the income management risks are real. Horizon will surely be monitoring that. Hopefully, they will also have a plan to shift to a conventional structure or make other changes before the corporate taxes kick in.
They may also come up with other innovative management solutions along the way that I haven’t even considered. They have before.
Still, it will be useful to model what hitting a tax-berg in a mutual fund corporation looks like. Just in case of foggy markets or captain-error. We’ll do that in the next post. Like an iceberg, the taxes on an eligible dividend distribution on the surface are easy to spot. However, there is much more lurking beneath the surface.
This series of posts has complex material. I would like to thank Benjamin Felix (Head of Research, PWL Capital) for helping me to identify issues, understand nuances, and find data. I am also grateful to the folks at Horizons ETFs for answering our tough questions as honestly and completely as possible. This post is not endorsed by anyone and any errors are my own. I try to be accurate and complete, but this is complex material. If I get something wrong, please let me know (with references if applicable) so that I can fix it.