One of the big drivers behind ETFs’ popularity has been their lower cost. But management fees are only one component of those costs; taxes are another significant expense investors face. In many ways, the taxes investors pay on income distributions can far outweigh the costs associated with management. That’s one reason why Horizons ETFs has seen a big uptick in the sales of its family of Total Return Index [TRI] ETFs.
In 2010, Horizons took notice of the frequent use of total return swaps by larger Canadian pension plans and launched the first of what would become a suite of 14 TRI ETFs, each of which provides tax-efficient access to some of the investment world’s most popular index strategies. The company recently bolstered its TRI ETF lineup with the Horizons Equal Weight Canada REIT Index ETF (HCRE), which tracks a Solactive index of Canadian REITs, and the Horizons Equal Weight Canada Banks Index ETF (HEWB), which provides exposure to Canada’s Big Six banks. Horizons also reportedly has a preferred share TRI ETF in the works.
Horizons remains the only ETF provider in Canada to offer investors this specific tax-advantaged approach. “A TRI ETF is a synthetic structure that never buys the securities of an index directly,” explains Mark Noble, Horizons ETFs’ senior vice-president of ETF strategy. “Instead, the cash portion of the ETF is put into an interest-earning cash account. The TRI ETF then provides the investor with the total return of the index by entering into a total return swap agreement with one or more counter-parties, typically large financial institutions, which will provide the ETF with the total return of the index in exchange for the interest earned on the cash deposit. Any distributions that are paid by the index constituents are reflected automatically in the net asset value [NAV] of the ETF. “As a result,” Noble continues, “the investor only receives the total return of the index, which is reflected in the ETF’s unit price, and is not expected to receive any taxable distributions directly. This means that an investor is only expected to be taxed on any capital gain that is realized if and when holdings are sold.”
TRI ETFs achieve their tax efficiency by allowing the value of their distributions to be reflected directly in their net asset value, rather than paid out separately as a taxable distribution. “It really benefits those investing in non-registered accounts, and TRI ETFs offer the potential for better after-tax returns,” Noble says.
High-net-worth clients in particular often are more concerned about the tax paid on dividends or other types of income distributions than they are about management fees. By using TRI ETFs, Noble points out, investors can potentially save on dividend taxes.
“Let’s say there is a dividend on an underlying stock of 2%,” he says. “Whether you decide to reinvest that or not, you are going to pay tax on it, which could be taxed anywhere from 25% or to more than 50%, depending on your income level and whether they are Canadian or foreign dividends. That could cut the dividend in half. However, by using a TRI ETF, the dividend isn’t distributed to the ETF holder and is instead reflected in the ETF, typically resulting in no immediate taxation of dividends for the investor. Over time, this can potentially save investors hundreds or even thousands of tax dollars.”
Another key element of TRI ETFs is reduced tracking error. When an ETF physically replicates an index, it typically mandates that regular distributions, dividends or interest from the underlying securities be accrued during the year and paid out on a scheduled distribution date. As a result, the cash held within the structure does not participate in the index returns, creating a drag on the performance of the ETF. This, combined with the ETF’s transaction costs from rebalancing, contributes to tracking error. In a total return swap structure, these issues are essentially eliminated since the counterparty delivers the total return of the index. Thus, a TRI structure can greatly reduce the potential for tracking error.
The appeal of the TRI ETF suite’s tax efficiency has allowed Horizons ETFs to compete with larger players and become the fourth largest ETF provider in Canada. “When we came to market, there wasn’t a lot of space for us to compete with the larger companies,” Noble says. “We needed to differentiate ourselves, and one way we did that was by offering these tax-efficient funds.”