Horizons BetaPro has announced that it is introducing the Horizons BetaPro S&P/TSX 60 Index ETF (HXT) that seeks to replicate the performance of the S&P/TSX 60 Index (Total Return) for a headline-grabbing Management Fee of just 7 basis points (0.07%). HBP says that it will bear all other expenses except the sales tax. Assuming the ETF ends up paying the full 13% HST, the all-in MER of the fund should weigh in at just shy of 8 basis points. The new ETF will be significantly cheaper than the iShares S&P/TSX 60 Index Fund (XIU), which charges a management fee of 15 basis points (0.15%) but remains one of the largest and most liquid ETFs available to Canadian investors wanting broad exposure to our equity markets (FD: I own XIU).

At first blush, the new ETF’s much lower cost sounds very attractive compared to competing products. But unlike XIU, which invests in and holds the securities that make up the underlying index, HXT plans to use derivatives such as total return swap agreements to gain exposure to the index. In my opinion, the use of derivatives makes HXT an unsuitable core Canadian equity holding for the following reasons.

Counterparty Risk

Investors in HXT are taking a credit risk on the payments that the ETF expects to receive from its counterparties. If the counterparty (The Globe and Mail reported that the initial counterparty is National Bank) becomes bankrupt, unitholders will not have any recourse against its assets but will have an unsecured claim against the counterparty. Therefore, in the event of a counterparty default, investors in HXT will see a decline in the value of their investments independent of any changes in the value of the S&P/TSX 60.

Swap Fees

According to the prospectus, the ETF will not initially make any fee payments to the counterparty to the swap agreement. But these agreements may be amended in the future and expenses may be incurred for the swap transactions. Swap fees can easily erase any MER advantages that HXT may currently have.

Unclear Tax Treatment

An investor in XIU receives ongoing income in the form of dividends. In a taxable account, an investor will incur tax liability on the dividends but qualified dividends receive favourable tax treatment. Due to its low expected turnover, investors in XIU will face little in the way of ongoing capital gains taxes. It is hard to determine from the prospectus whether HXT, which employs derivatives, can be expected to offer better after-tax returns than XIU.

Bottom line

Horizons BetaPro is going to garner a lot of headlines for launching what it calls “Canada’s Lowest Cost ETF”. The stated management fee of 7 basis points (0.07%) is half that of XIU. While that sounds very attractive, HXT’s financial engineering isn’t what you could term simple and easy-to-understand. The counterparty risk alone, though very low, may be sufficient reason for those investors who simply want broad exposure to Canadian stocks to avoid this ETF.

You can read the news release here. The ETF Prospectus is available on SEDAR.

This article has 42 comments

  1. Nice analysis. I’m leery of any fund that uses derivatives including hedged currency funds.

  2. Good analysis Ram.

    What I don’t understand is why they would try to undercut the best deal in Canadian ETFs. XIU is cheap enough. Another 7 basis points is almost meaningless.

    iShares REIT ETF (XRE) with an mer of 55 bps is a far more logical (albeit smaller) ETF to compete against.

    Mike

  3. Thanks for the information on a new product.

    I’m wary of anything that takes a concept aimed at simplicity (low-effort passive index investing) and makes it more complex. I think I’ll stay away…

  4. Good post. Does the product info mention the expected tax treatment? Reminds me a bit of the Claymore Global Monthly Advantaged Income Fund (CYH) that uses forward agreements with the National Bank to turn foreign income into capital gains, which is beneficial to a Canadian taxable investor/account. Since CYH has been around for two years I presume it is ok by the CRA. Of course, turning dividends into capital gains is a net loss, tax-wise. Maybe Horizons BetaPro should do this for a S&P500 tracker to turn that foreign dividend income (not eligible for Cdn dividend tax credit and taxed as ordinary income) into cap gains and offer a low MER to boot. It would be more interesting than this ETF.

  5. Hmmm, Wealthy Boomer’s article on this ETF says BetaPro claims the capital gains will be deferred till you sell the units. Nothing showing up on your annual T-slips? Huh? We need some tax experts to figure this out.

  6. @Michael: The counterparty risk is limited to 10% of NAV and the risk of a default may be low but investors should carefully consider if it is a risk they would like to take in exchange for 10 basis points or so. The tax treatment is not very clear from the prospectus.

    @MoneySmartsBlog: Good point. I don’t understand why competitors are not attacking XRE either. That’s an obvious place to compete on management fees.

    @CanadianInvestor: HBP says that the value of any dividends are immediately attributed to the NAV. So, S&P/TSX 60 Total Return should have higher expected return than the S&P/TSX 60 because dividends are immediately reinvested.

    HBP also says the ETF will not make quarterly distributions and is not expected to make annual distributions. I’m not clear on the latter point. Does a taxable event occur when the swap agreement expires or is terminated? Time for the tax experts to weigh in, I think.

  7. While we can analyze the negatives of this product until the cows come home, I think we need to look at the positive here – that is – a new low mer product is being introduced in the Canadian market. It may not be the right product for me or you, but this is a good thing and we need to hope that there is a trickle down that leads to new low MER product offerings, or the lowering of MERs on traditional offerings (including both ETF and mutual funds).

  8. @Greg: Absolutely agree. I concur that competition is a good thing and competing low-MER products put pressure on current market leaders. One of the reasons big banks reduced commissions for many investors is the pressure from small discounters who were offering $5 and $10 trades. In that sense, I think HBP should be applauded for introducing this product even if I personally may not invest in it.

  9. @Greg: To add to my previous point, I want to clarify that I did not intend this post as a criticism of HBP introducing HXT at all. I was genuinely interested in whether HXT could be an alternative to XIU for future savings (my XIU is in a taxable account and switching would trigger a taxable event) and I found enough issues to at least adopt a wait-and-watch attitude. I’m especially confused with the tax treatment even after reading the prospectus a couple of times. If HBP is able to defer capital gains and dividends until HXT is disposed, it will be a powerful argument in favor of owning the ETF.

  10. Unfortunately, the tenor of your original post seemed overly negative; the risks are low and cheaper is often bettter. Let’s continue to monitor and evaluate.

  11. I guess with XIU assets reaching 12 billion(?), other companies cannot help but salivate at the gravy train passing them by. Hence, the new products from BMO, Horizon, etc. Good for competition!

    Your post also shows how different ME can be from the true MER. As an investor, you want to know the MER not ME.

    Good post as always CC.

  12. I think it’s interesting that Horizons has created an index-tracking ETF and is trying to compete with iShares on price. I would have thought they would continue down the road of actively managed ETFs that go head-to-head with mutual funds.

    If I had to compile a list of products that Canadian investors need, a cheaper TSX 60 ETF would not be at the top. A lower-cost challenger to XRE would be nice, as mentioned by others. How about a broad-market US equity ETF that covers more than just large caps? Or a global bond ETF hedged to Canadian dollars?

  13. Just look up SEI – Synthetic-Funds, to see how this is going to work,but with a way lower MER

  14. Good post. I will continue to hold XIU in my RRSP because, for the reasons you outlined above for HXT, I understand XIU that much better.

    Cheers,
    Mark

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  16. cf Jay’s comment … found this in the SEI prospectus “The Funds may undertake derivative activities, including the holding and trading of futures contracts to achieve a return that is similar to the stock exchange or bond index which represents the target return for the Fund. Generally, gains and losses realized by a Fund in connection with derivative activities will be treated as being on income account and not as capital gains or capital losses.”

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  18. HBP responded to this post saying that the risks are overstated. Their response is available here:

    Link

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  23. @Canadian Capitalist-> Any low fee ETF dividends for Canada recommendations?

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  27. Hi,

    All this theory is good but has anyone looked at the actual performance of HXT on a chart versus XIC and XIU? Something I don’t get. If its supposed to deliver 0.07% tracking error plus automatically reinvested dividends, then there is a problem because it is constantly trailing the index.

    What am I not getting? XIC is beating XIU recently because small caps are doing better (still not good, but not as bad) but HXT should be significantly higher than since its basically index – 0.07% + automatic DRIP …

    • @Jerome: HXT should be compared to XIU because both these ETFs track the same index. HXT should show less tracking error than XIU because (a) the MER is cheaper and (b) the index tracking methods are completely different (HXT employs a swap to track the index whereas XIU holds the stocks directly). I believe Rob Carrick recently reported that HXT’s tracking error was exactly 0.07% but XIU’s was of the order of 0.17%.

  28. Thank you again for your reply.

    So their tracking errors is exactly equal to their MER? That would be nice in theory, but every chart I look at says otherwise. Do you have a link to that article?

    • @Jerome: Which chart are you looking at? Are you comparing XIU to HXT? I don’t have a link to Rob’s article because it was available through TD Waterhouse but here are the relevant sections.

      “Some research by National Bank Financial highlights the ETFs that are doing the best job of tracking their respective indexes. Here are some highlights in the Canadian equity category:

      -The Horizon S&P/TSX 60 ETF (HXT) is performing “exceptionally well,” with an annualized drag on returns of 0.08 of a percentage point. That’s exactly what this ETF’s management expense ratio is. Note that HXT is atypical in that it uses derivatives to track the S&P/TSX 60 index rather than holding the actual component stocks.

      -The iShares S&P/TSX 60 Index Fund (XIU) and iShares S&P/TSX Composite Index Fund (XIC) have both performed well in terms of tracking their indexes.”

    • @Jerome: XIU pays a dividend but charts only show you price movements. HXT does not pay a dividend; so its price movements include dividends. XIU tracks the S&P/TSX 60 index. HXT tracks the S&P/TSX 60 Total Return Index. That explains the significant difference you see in the charts. You need to compare total returns of XIU with total returns of HXT. Hope this helps.

  29. Yeah I got this. Thats why I wrote “If its supposed to deliver 0.07% tracking error plus automatically reinvested dividends, then there is a problem because it is constantly trailing the index. (…) HXT should be significantly higher than since its basically index – 0.07% + automatic DRIP …”

    What I don’t get is, for example, why sometimes HXT deviates so much from the index in a negative way, i.e. : http://www.google.ca//finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1312488000000&chddm=8602&chls=IntervalBasedLine&cmpto=TSE:OSPTX&cmptdms=0&q=TSE:HXT&ntsp=0

    Are they not supposed to give the index return period per the swap agreement ? Then remove MER and add dividents and interests. Theoretically it should NEVER be under the index growth-wise. No?

  30. You’re absoluetly right. Sorry for the confusion! I am thinking going HXT to hold in nonreg acccount and avoid tax events with dividends and such. I understand the mechanics and the 10% NAV risk related to the couterparty (National Bank). I still think its worth it for tax purposes and low MER. Plus volumes are high (even higher than XIC on average, XIU is another story) so it should be fairly liquid.

    Thanks again!

  31. hxt is the better alternative for me since scotia charges zero commission to buy and sell it , it all adds up !

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  34. All, what’s the consensus now a few more years in? I’ve been a holder of XIU for a long time, but looking to do some rebalancing this year and HXT looks attractive. Comparing the total returns since inception in 2010, HXT is beating the pants off of XIU. And it looks a lot more than the 8 basis points difference in MER. Thoughts?

    • Canadian Capitalist

      @smoothmoose: In a registered account, I would replace XIU with a cheaper option such as VCE. That’s because the tax benefits offered by HXT’s swap structure is not so important in a tax-sheltered account.

      In a taxable account, HXT is interesting because it can help avoid taxes on dividend income stream but I personally avoid it still. That’s because I think there is a risk of an adverse tax ruling like the recent budget measures against “advantaged” products.

      PS: I still own XIU in my taxable account because it has significant capital gains. Any new investments will be in VCE.

      • Thanks CC. I think I’ve been taking the coach potato thing too seriously. I just notice my iTrade is now commission free on many ETFs including HXT, but not with XIU or VCE. So HXT is looking more tempting. Up until now I’ve been buying XIU every 3-4 months, but sometimes that slips due forgetting or by temptations to time the market (since I’m buying in larger chunks). I want to get more regular and just dollar cost average every 2-4 weeks. FWIW, I am talking about 6 figure portfolios both RRSP and taxable.

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