On September 14, 2010*, Horizons ETFs launched the Horizons S&P/TSX 60 Index ETF (“HXT”), which trades on the Toronto Stock Exchange under the ticker symbol HXT. At the time, HXT was the lowest-cost Canadian equity fund in the world, and with its current rebated management fee** of 0.03%, it still remains one of the lowest cost exchange traded fund (“ETF”) options available to Canadian ETF investors.
HXT seeks to replicate, to the extent possible, the performance of the S&P/TSX 60™ Index (Total Return), net of expenses. The S&P/TSX 60™ Index (Total Return) is designed to measure the performance of the large-cap market segment of the Canadian equity market.
In our view, the launch represented the first ETF in Canada utilizing ultra-low management fees – fees below 0.10%, which was followed by competitors lowering fees on similar index strategies. This ultimately brought about a competitive race to reduce fees that continues to this day and has resulted in potentially millions of dollars in savings for Canadian investors that have billions of dollars invested in HXT and other large-cap Canadian equity ETFs that have management fees less than 0.10%. (National Bank, September 30, 2020).
HXT was also the first ETF launched by Horizons ETFs Management (Canada) Inc. (“Horizons ETFs”) that uses our innovative Total Return Index (“TRI”) structure. The adjusted after-tax savings for taxable investors that have held HXT is arguably more impactful than the benefits of HXT’s low management fee.
The Horizons TRI ETFs that utilize total return swaps achieve tax-efficiency primarily by receiving the total return of the underlying index (before fees). The value of the underlying index constituent distributions are reflected in the ETF’s share prices and are not distributed to shareholders. This means that an investor is generally only expected to be taxed on any capital appreciation of the ETF if, and when, the shares of their ETF are sold.
The Total Return Advantage
HXT uses a synthetic structure, known as a total return swap.
Unlike a traditional physical replication ETF that typically purchases the securities found in the relevant index in the same proportions as the index, HXT uses a synthetic structure that never buys the securities of the S&P/TSX 60 Index (the “Underlying Index”) directly. Instead, HXT receives the total return of the Underlying Index by entering into total return swap agreements with one or more counterparties, typically large Canadian financial institutions, which provide the ETFs with the total return of the Underlying index.
Ten Years of Savings
Since its inception in September 2010, HXT has not paid a single taxable distribution. Instead, the value of any dividend distributions paid by the underlying stocks of the Underlying Index are reflected immediately in the net asset value of HXT, since the swap is required to replicate the total return of the Underlying Index, while the distributions are never physically received or paid out.
Investors are not expected to receive any taxable distributions directly. This makes HXT particularly advantageous if its shares are held in a taxable account, where tax on Canadian eligible dividend distributions could potentially be in excess of 30%, depending on the marginal tax rate of the investor. With this structure, investors can potentially defer incurring a tax liability until they sell HXT, at which point a portion of the proceeds from the sale of HXT would likely be taxed as a capital gain.
Since HXT now has ten years of performance, we compared it to the only other index ETF in Canada that has offered direct exposure to the same Underlying Index over the same time-period, the iShares S&P/TSX 60 Index ETF (“XIU”), which trades on the Toronto Stock Exchange under the ticker symbol XIU.
Some Important Differences Between HXT and XIU
XIU is a physically replicated ETF that holds the underlying 60 stocks associated with the Underlying Index. This means XIU has minimal credit risk associated with it, but also could incur additional trading costs associated with replicating the Underlying Index. However, historically, XIU has tracked the price return of its Underlying Index exposure closely.
HXT on the other hand, does have some credit risk associated with the fact that it is the obligation of the swap counter-parties on HXT to deliver the returns of the Underlying Index, which means the returns are dependent on the creditworthiness of these counterparties. In the case of HXT, these counterparties are Schedule 1 Canadian Banks, such as the Big 6 banks.
HXT has a lower management fee, currently rebated to 0.03% plus applicable taxes, and a management expense ratio (“MER”) also at 0.03%, as at June 30, 2020, whereas XIU has a management fee of 0.15% and an MER of 0.18%, as at June 30, 2020. Even before factoring in taxes, HXT generally would be expected to generate better returns than XIU simply because it offers exposure to the Underlying Index, at a lower cost point. However, according to the Regulatory ETF Fact sheets from each ETF (as at September 30, 2020, for XIU and August 26, 2020, for HXT), the average bid/ ask spread on HXT is 0.05% whereas it is 0.04% on XIU.
In the below hypothetical comparison of ten-year returns, which is based on the actual historical total re- turns of each ETF for the period ended September 14, 2020, we make the following additional assumptions:
1. The tax calculations are based on the historical Canadian tax rate for an Ontario resident that would earn an income in excess of $220,000 a year.
2. All distributions are fully reinvested.
3. Distributions on XIU are paid and reinvested quarterly.
4. Tax is paid annually.
5. Taxes are paid using existing (and reinvested) capital by selling the required number of ETF shares/units to pay for the tax on distributions (if any) and capital gains (if any) from the sale of those ETF shares/units. This is important, as we assume reinvestment of distributions and need to ensure the full compounding of those distributions over the period analyzed.
6. The end date is treated as being equivalent to year-end for the purposes of taxes on distributions.
As you can see in this hypothetical comparison, when factoring in the tax rate and fee differentials, HXT would have delivered an annualized return of 5.02% since inception versus a 4.51% return for XIU over the same period. On this hypothetical C$1 million investment, this would have been substantial; with an investor in XIU paying approximately C$134,380.77 is taxes on dividends received. Even when we factor in selling the units of HXT at the end of this period, which would result in a large capital gains tax, HXT would still have generated an additional after-tax re- turn of nearly C$78,400 versus XIU or approximately a 7.84% difference on the initial investment.
Source: Bloomberg, Horizons ETFs (Canada) Inc. as at September 14, 2020.
What’s crucial to highlight is that in both cases, the ETFs have effectively the same exposure to the Underlying Index. These potential savings don’t come from the underlying exposure of the constituents in the index but from the potentially significant tax and fee savings offered by HXT.
Our belief is that the single biggest determinant in index investing success is minimizing the costs associated with replication of that exposure. As HXT highlights, costs are more than just the management fees; the combination of improving tax efficiency while keeping management fees low can result in potentially substantial long-term savings that help improve the overall return profile of an ETF.
For 10 years, that’s been the advantage of owning HXT for Canadian equity exposure, and more broadly, this is the Index Advantage™ offered by Horizons’ Family of Total Return Index ETFs.
HXT: Seeks to replicate, to the extent possible, the performance of the S&P/TSX 60™ Index (Total Return), net of expenses. The S&P/TSX 60™ Index (Total Return) is designed to measure the performance of the large-cap market segment of the Canadian equity market.
XIU: Seeks long-term capital growth by replicating the performance of the S&P/TSX 60 Index, net of expenses.
Source: Bloomberg, Horizons ETFs (Canada) Inc. as at September 14, 2020. * HXT Inception Date: September 14, 2010.
The indicted rates of return are the historical annual compounded total returns, including changes in unit/share value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Additionally, Index returns do not take into account management, operating or trading expenses or income taxes payable that may be incurred in replicating the index. The rates of return shown are not indicative of future returns. The ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. The index is not directly investible.
**0.07% rebated by 0.04% to an effective management fee of 0.03%, until at least January 1, 2021 (Plus applicable sales taxes).
Commissions, management fees and applicable sales taxes all may be associated with an investment in the Horizons S&P/TSX 60™ Index ETF (the “ETF”) managed by Horizons ETFs Management (Canada) Inc. The ETF is not guaranteed, its values change frequently and past performance may not be repeated. The prospectus contains important detailed information about the ETF. Please read the prospectus before investing.
Horizons Total Return Index ETFs (“Horizons TRI ETFs”) are generally index-tracking ETFs that use an innovative investment structure known as a Total Return Swap to deliver index returns in a low-cost and tax-efficient manner. Unlike a physical replication ETF that typically purchases the securities found in the relevant index in the same proportions as the index, most Horizons TRI ETFs use a synthetic structure that never buys the securities of an index directly. Instead, the ETF receives the total return of the index through entering into a Total Return Swap agreement with one or more counterparties, 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 held by the ETF. Any distributions which are paid by the index constituents are reflected automatically in the net asset value (NAV) of the ETF. As a result, the Horizons TRI ETF receives the total return of the index (before fees), which is reflected in the ETF’s share price, and investors are not expected to receive any taxable distributions. Certain Horizons TRI ETFs (Horizons Nasdaq-100 ® Index ETF and Horizons US Large Cap Index ETF) use physical replication instead of a total return swap. The Horizons Cash Maximizer ETF and Horizons USD Cash Maximizer ETF use cash accounts and do not track an index but rather a compounding rate of interest paid on the cash deposits that can change over time.
The information contained herein reflects general tax rules only and does not constitute, and should not be construed as, tax advice. Investors’ situations may differ from those illustrated. Investors should consult with their tax advisors before making any investment decisions.
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