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.
Conclusion
I don’t think HXT is as complex or risky as some of the early commentary would suggest.
What’s in it for National Bank?
Floating rate payment for sure, offsetting risk of proprietary positions possibly, and perhaps acting as a swap dealer for other products. Perhaps next week I’ll discuss swap dealers and how they make money.
Maybe National Bank uses it as a hedge against their long equity positions?
@Slacker: that’s exactly what I’ve been wondering. From what I know so far it falls under the “too good to be true” heading.
Thanks for the explanation, Preet. How big could HXT get and still have enough counter-parties to cover it? I’m sure that BetPro would love to get so big that this became a problem, but it’s not clear to me what happens if HXT grows by leaps and bounds for several years and there is a shortage of counter-parties.
This type of business is so big in the institutional world they are but a drop in the ocean at this point. Even if they reached XIU scale at $11 billion, the most amount of risk a counterparty would have would be $1.1 billion. If they have offsetting positions acting as a swap dealer they could even be market neutral with respect to their operations. Further, Horizons or National would do something about the situation if either of them felt it was getting too big for National – it’s not like it goes unmonitored.
As in my reply to Slacker, I think I’ll do a post on swap dealers next week. Pretty interesting stuff.
It seems to me that from Horizon’s perspective, there is no risk as all the risk is borne by the unit holders of the ETF. Horizon collects their 0.07% MER. So for every $1M in NAV for HXT, Horizon collects $700 in fees. Considering that IShare’s XIU has an NAV of over $11B, any share of that pie that HXT can take from XIU is free money with no risk.
From National’s perspective, it benefits in a down or sideways market while collecting the floating rate interest from the swap. In an upward market, National would have to provide a return equal to the TSX/60 index, but that can be mitigated with long-term options. Considering the current market environment, and predictions of flat growth for the next few years, the risks of a rising markets are low (but not zero).
For unit holders, I suppose they would have to weigh the tax efficiencies of HXT vs. the risk of counterparty default. Also, is the savings in MER they would derive from holding HXT vs. XIU be worth it? Currently, the difference is 0.10%. That’s about $1 for every $1000 invested.
@Huy: I’m sure you know this, but I just wanted to highlight that the MER is an annual expense, so on $1 million, it’s not just $700, but rather $700/year.
And a TD E index fund would be $1200/per year and a 130/30 index would be $2000 per year on ! million
Great article Preet – thanks for clearing this up.
Mike
Great post, Preet. Thanks for explaining things.
Preet says: “The interest rate on the cash held by HXT is sufficient to fund the floating rate payment to the counterparty.”
Maybe they could tell us where you get at least 5% interest these days.
This sounds like a scheme whereupon new ‘investors’ provide the liquidity/float to cover potential persistent cash calls by National Bank. Based on actuarial probabilities, it may be anticipated that there shouldn’t be many cash calls in a row, but…things happen.
And if they did get actually get 5% a year interest on their cash pile, one 5% cash call for one day would eat up a year’s interest, the next 5% cash call starts eating the investors’ cash (AKA HXT’s cash).
Also, you say ‘If National Bank goes bankrupt, then the contract is void’, if HXT has a bad day but National Bank goes bankrupt. But don’t the trustees in bankruptcy for National Bank have a duty to collect all monies owed to National Bank as they would in any bankruptcy?
I’m not clear where the 5% you mention comes from Robert – the floating rate payment from HXT to NB is based on prevailing interest rates (independent of returns of the index). The swap fee is zero for 5 years.
Second part – yes, worst case scenario for HXT holders is they make the payment to NB as the trustee will try to secure payment, best case scenario is they don’t.
So why on earth would National Bank agree to pay market returns in exchange for interest payments of … zero? I still don’t see what’s in it for NB.
A swap fee is separate from the floating rate payments. I can’t speak for NB, but they could be acting as swap dealer and have an offsetting trade and simply be picking up interest with no market exposure.
Also remember that NB hold 20% of Horizon
So in that case, someone else would be offering NB market returns AND interest, while NB pays market returns to HXT and earns interest? That just begs the question: who would that “someone else” be?
That sounds awfully like the bigger fool theory of investing: NB doesn’t mind paying market returns in exchange for nothing, because they know someone else who is willing to accept an even worse deal.
Sorry man, but I think your blog post has demonstrated very clearly that this fund is too complex for the ordinary investor to grasp. Every simple explanation I’ve seen has been too good to be true, so the reality must be complex, and that makes it risky. I’ll definitely be avoiding this one.
Funny how people re-act when they don’t understand something…HXT now has the lowest MER at 0.05 ya that is lower then VCE and trades way better volume then VCE. Tracking error is min. with XIU or HXT but VCE is a T.R. dog, I have the data to back up this statement .
@dj: Sorry, what’s the funny part? Avoiding investments one doesn’t understand seems quite reasonable to me.