Horizon’s BetaPro made a lot of headlines last week when it announced it was launching HXT, a Canadian-listed ETF that tracks the S&P/TSX 60 Total Return Index with a management fee of only 0.07%. With HST of 13%, the expected MER is roughly 0.08%. First, commentators pointed out the rock-bottom fee. Then the attention moved to the synthetic structure and questions arose as to complexity and risk. I think it’s been well overblown.
What Makes HXT Different Than XIU?
XIU, the incumbent, holds the underlying stocks of the index. Dividends received on the portfolio are flowed through to the investor. Very simple.
HXT instead uses a Total Return Swap with a Counterparty in lieu of holding the underlying stocks. HXT holds cash itself. The counterparty promises to exchange the return of the S&P/TSX 60 Total Return Index for a payment from HXT (explained below). They “swap” returns. This is a contract between the two parties and can allow for rock-bottom tracking error for HXT. (Tracking error is harder to manage for index funds than most people probably believe.)
Further, since the swap is for the Total Return (which means the performance includes the re-investment of dividends generated by the index), there is some tax benefit to holding HXT in non-registered accounts since dividend income (which is taxed annually) is converted into deferred capital gains.
What Have The Commentators Being Saying
The main arguments are that HXT is too complex because it uses an exotic derivative, it’s exposed to the credit risk of the swap counterparty, and the tax treatment is unclear. Allow me to clear these up in turn.
Complex Structure: Not Really
I think some people see the word “derivative” and remember all the talk of toxic derivatives of the credit crisis, and therefore assume all derivatives are high risk. Here’s how HXT’s Total Return Swap works: HXT holds cash. National Bank (the counterparty) agrees to exchange the returns on the total return index for a payment from HXT linked to a floating rate of interest (tied to prevailing rates). If the total return index increases by 5.0%, then National Bank sends a payment equal to 5.0% of the notional value to HXT. If the total return index decreases by 5.0% then HXT sends a payment to National Bank. The interest rate on the cash held by HXT is sufficient to fund the floating rate payment to the counterparty. Nothing really complex here.
Counterparty Risk: Not Much
A couple of things to point out here. The counterparty risk is limited to 10%. Seems like a simple statement but I think it has been misinterpreted to mean that if the counterparty goes bankrupt (which in and of itself is unlikely, however possible) then you would lose 10% of the ETF’s NAV. What it really means is that the notional value of the of total index return cannot exceed 110% of the cash held by HXT without HXT doing something about it for regulatory reasons. For example, if HXT is holding cash and the index goes up 20% in a day, the counterparty suddenly is on the hook for a lot of money that might need to be paid to HXT (depending on the timing of the swap payments). If this happens, HXT has the option of engaging a second counterparty (or more than one) in order to bring each counterparty’s risk to under the 10% limit allowed. I believe it also has the option of asking for a swap payment to be made between regular payment dates.
What would have to happen for the ETF to lose 10% of it’s NAV due to counterparty bankruptcy? The index would have to spike upwards faster than HXT would be able to react and engage other counterparties and National Bank would have to be unable to pay the swap payment. For the index to spike that fast would require one company absolutely shooting the lights out overnight (not likely with a TSX 60 company), or there would have to be a systemic increase in prices. Such a condition would likely not occur with ONLY National Bank facing bankruptcy.
The flipside is if the index plummets quickly overnight, then HXT owes money to National Bank. If National Bank goes bankrupt, then the contract is void and the index return would be lower than HXT’s return since HXT would not make the payment to National (and remember, HXT holds cash). In this case you would be better off! If HXT did make the payment, then you end up with the index return (which is what you bargained for).
So: counterparty risk? Misinterpreted.
Tax Treatment Unclear: Nope
A common return swap can be found between a bond fund manager and an equity fund manager. They can swap the performance with each other and in effect the equity manager could say that he is running a tax-efficient bond mandate for his investors (as is the case in a capital yield class or a managed yield fund where the investor receives fixed-income type risk and returns with the distributions treated as capital gains). These arrangements have been around for many years, and there are billions invested in these retail funds. If you look up the portfolio holdings they (these days) show you the holdings of the “reference fund” and it is usually indicated as such. Capital yield class funds have for years been able to exchange less favourable distributions for deferred capital gains treatment. This is nowhere near new.
I don’t think HXT is complex or risky. If I invested in cap-weighted indices, I would put new money into HXT over XIU personally. But I don’t have a penny in cap-weighted ETFs or mutual funds as I’m a firm believer in Fundamental Indexation. (Disclosure: I work for an fundamental index fund manufacturer.)