Investing in non-North American equities can be more complex than buying equities listed in the United States and Canada, since foreign equity markets trade at different times. For example, Asian equity markets are generally closed while North American equity markets are open and vice-versa.
This typically increases the operational cost of running an ETF that invests in foreign equities, since stale pricing data from that market’s prior day, or unavailable pricing data, may negatively impact the ETF provider’s ability to operationally trade and rebalance securities on foreign exchanges. It also may negatively affect the creation redemption process by increasing authorized participants’ trading costs and hedging needs. It begs the question: how do you a value a security that is not currently trading?
Futures: A Liquid Solution for Foreign Equities Outside of North America
A futures contract is a legal agreement to buy or sell a particular commodity asset or security at a predetermined price at a specified time in the future. Futures contracts are standardized and trade on a futures exchange. Equity index futures are cash-settled based on the settlement value of the contract, and can be traded electronically 24/7. They can be used for a variety of purposes, including hedging, adding leverage to a portfolio, speculating on the future value of an index and equitizing unused cash. They are used by a variety of participants including institutions, investors, traders and investment funds, to name a few.
Directly replicating an index that holds foreign equities requires authorized participants and ETF providers to trade and hold inventory in constituent securities when North American equity markets are open and when international equity markets could be closed. This can potentially increase the cost of running an ETF that seeks to directly track foreign equities and may lead to liquidity, pricing and spread disadvantages for ETF investors. Authorized participants will likely already be using index futures as a part of their hedging process for any foreign equity exposure in the ETFs. By directly targeting a futures-based index — which reflects the returns generated over time through fully collateralized, long notional investments in a series of equity index futures — rather than the foreign-listed securities themselves, authorized participants only need to trade and hold inventory in highly liquid futures contracts.
Total Return Index Structure†
Horizons ETFs offers three corporate class index ETFs that track international equity markets: the Horizons Intl Developed Markets Equity Index ETF (“HXDM”), the Horizons EuroStoxx 50 Index ETF (“HXX”) and the Horizons Emerging Markets Equity Index ETF (“HXEM”), all are part of the Horizons Total Return Index family of ETFs and track futures-based, rather than equitybased, indices.
The Horizons international equity index ETFs do not physically hold the underlying constituent securities of their respective indices. Instead, their returns are delivered via swap agreements with acceptable counterparties: Schedule 1 Canadian banks with a minimum A credit rating. The swap agreement is a binding contractual obligation to deliver the daily returns of the indices to the ETFs, which are markedto- market each day based on the change of the indices. Counterparties are legally obligated to deliver the exact Index returns, before fees.
When combined with the total return swap, the use of a futures-based index allows the ETF provider’s counterparties and market makers to more directly and efficiently hedge their exposure and eliminates the need for the ETF provider, its counterparties, and its market makers to trade, rebalance, and directly hold inventory in a portfolio of foreign equities. This can potentially reduce operational costs and lead to improved liquidity, pricing and spread advantages to end ETF investors.
What’s the Trade-Off?
While equity index futures and our futures indices are closely related to their underlying indices, the use of equity index futures can introduce basis risk: the risk that the performance of futures contracts diverges from the performance of the underlying index.
Since equity index futures do not convey any rights of ownership to foreign equities, including the receipt of dividends and voting rights, and also do not require an exchange of cash for the purchase or sale of constituent securities outside of margin requirements, typically futures prices adjust for the net cost of carry. A variety of other factors — including liquidity needs, hedging demand and the balance of speculative directional bets on the future value of the index — can also affect futures prices and may contribute to a change in the basis. This is the most important thing to note: historically, the longterm effect of potential basis risk has been muted; the performance differential between futures-based indices, like those employed by our foreign equity index ETFs, and the underlying indices that the futures contracts track are not all that different. In our view, the potential liquidity, pricing and spread advantages for these ETFs relating to the use of futures-based indices constitutes a positive trade-off for the introduction of some basis risk over shorter holding periods. Investors can see the index exposure of the futures roll indices has historically been very similar to the actual broad indices themselves.
HXDM: The Horizons Intl Developed Markets Equity Index ETF seeks to replicate, to the extent possible, the performance of the Horizons EAFE Futures Roll Index (Total Return), net of expenses. The Horizons EAFE Futures Roll Index (Total Return) is designed to measure the performance of large-and mid-cap securities across 21 developed markets including Europe, Australasia and the Far East, excluding the U.S. and Canada.
The table below shows the historical difference between the Futures Roll Index vs. the actual MSCI EAFE Index, both indices are reflected in U.S dollars.
The indicated rates of return are the historical annual compounded total returns, including changes in 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 that may be incurred in replicating the index. The rates of return above are not indicative of future returns. The ETF is not guaranteed, it’s values change frequently, and past performance may not be repeated. The indices are not directly investible.
* The Horizons EAFE Futures Roll Index (Total Return) reflects performance for the period from June 30, 2015 and includes hypothetical back-tested data for the period from June 30, 2015 to September 5, 2017
HXX: The Horizons EuroStoxx 50 Index ETF seeks to replicate, to the extent possible, the performance of the EURO STOXX 50® Futures Roll Index (Total Return), net of expenses. The EURO STOXX 50® Futures Roll Index (Total Return) is designed to measure the performance of 50 of the largest companies that are sector leaders in the Eurozone.
Again, you can see that the performance of the Futures Roll Index has been very similar to the performance of the EuroStoxx 50. In this example, the index returns are in Canadian dollars.
Source: Bloomberg as at June 30, 2020.
The indicated rates of return are the historical annual compounded total returns, including changes in 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 that may be incurred in replicating the index. The rates of return above are not indicative of future returns. The ETF is not guaranteed, it’s values change frequently, and past performance may not be repeated. The indices are not directly investible.
HXEM: The Horizons Emerging Markets Equity Index ETF seeks to replicate, to the extent possible, the performance of the Horizons Emerging Markets Futures Roll Index (Total Return), net of expenses. The Horizons Emerging Markets Futures Roll Index (Total Return) is designed to measure the performance of large- and mid-cap securities across 26 emerging markets countries.
HXEM is a new ETF that has less than a year of performance but you can see that similar to HXDM and HXX, the performance of its index is closely correlated to the MSCI Emerging Markets Index. In this example the returns are in U.S. dollars.
Source: Bloomberg as at June 30, 2020.
The indicated rates of return are the historical annual compounded total returns including changes in index unit value and reinvestment of all distributions and does not take into account sales, transaction, brokerage, redemption, distribution or optional charges or income taxes payable by any investor or investment fund in replicating the indices, that would have reduced returns.The indices are not directly investible. Index returns are not guaranteed, their values change frequently and past performance may not be repeated.
HXDM, HXX and HXEM are corporate class ETFs that are part of Horizons Total Return Index ETF suite of products.
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, its return is delivered via swap agreements with acceptable counterparties: Schedule 1 Canadian banks with a minimum A credit rating. The swap agreement is a binding contractual obligation to deliver the daily returns of the Index to the ETF, which is marked-to-market each day based on the change of the Index. Counterparties are legally obligated to deliver the exact Index returns, before fees.
Under this structure, investors are only expected to receive the total return of the Index, which is reflected in the ETF’s share price. Investors are not expected to receive any taxable distributions directly.
Distributions made by foreign companies are not eligible for the Canadian dividend tax credit and are taxed in the hands of Canadian residents as income at the marginal tax rate of the investor. This makes these ETFs particularly advantageous if held in a taxable account, where tax on foreign dividend distributions could potentially be in excess of 50%, depending on the marginal tax rate of the investor. With this ETF structure, investors can potentially defer incurring a tax liability until they sell their shares of the ETF, at which point proceeds from the sale of ETF units would likely realize either a capital gain or capital loss. Distributions from foreign jurisdictions received by Canadian-domiciled foreign equity ETFs are also typically subject to withholding tax at a rate that is dependent on the tax treaty between Canada and the originating country which can further erode the return of a physically replicated ETF held in any type of account. Our non-North American foreign equity index ETFs would not be subject directly to foreign withholding tax since they do not actually receive physical distributions.
Taxation on Foreign Equities
The following hypothetical example shows the tax impact on the returns of a Canadian-domiciled foreign equity ETF that pays an annual dividend of 3%. This example does not take into account any management or operating fees, or expenses that would be associated with an ETF purchase. Both ETFs are held by an Ontario resident investor in the third-highest marginal tax bracket, who would have an income tax rate of 47.97% in 2020. In this example, there is no application of the withholding tax on the dividends, which is another consideration that could negatively impact an investor’s return on a Canadian-domiciled foreign equity ETF regardless of the type of account the ETF is held in. It is important to note that none of the Horizons Total Index Return ETFs re-characterize investment income as capital gains.
FOR ILLUSTRATIVE PURPOSES ONLY. The above illustrative example highlights the expected after-tax performance benefits of holding TRI Foreign Equity ETF versus another Canadian domiciled physically replicated foreign equity ETF in a non-registered account, assuming both ETFs earned/reflected a net 3% dividend and track the exact same universe of stocks. This example does not take into account any fees or expenses of the ETFs, foreign withholding taxes, or any commissions, fees or expenses that would be associated with the purchase or sale of the ETF units/shares. The example also does not contemplate any sale of the ETF units/shares or any tax liability that would result. **Both ETFs are held by an Ontario resident investor in the third-highest tax bracket, who would have a marginal tax rate of 47.97%, on international dividends, in 2020. It also assumes no change in the market value of the Index constituents.
Key Features of HXDM, HXX and HXEM:
• Liquid exposure – real time pricing – on key foreign equity benchmarks, including the MSCI EAFE, MSCI Emerging Markets Index and EuroStoxx 50 Index
• None of these ETFs are expected to make taxable distributions, making it advantageous for taxable accounts where foreign dividends are taxed at the marginal income tax rate of a Canadian resident
• No foreign withholding tax
• No T-1135s