Understanding Total Return SwapUnderstanding Total Return Swap (TRS) Horizons ETFs believes that investors should pay as little as possible for market returns. A total return swap (TRS) is an innovative approach to delivering Canadian market returns in a cheaper and more tax-efficient manner.
A TRS is commonly used by large institutional investors. It is simply an agreement between investors and a large financial institution (the “counterparty”) whereby the investors exchange (or “swap”) their capital, which is held as cash in a custodial account, for the total return delivered by another asset such as a stock market index.
Key Benefits of a TRS for an ETF
• Lower Fees: The TRS structure reduces the trading expenses that are associated with traditional funds that replicate an index by purchasing all the individual underlying stocks of a portfolio
• Improved Tracking: Since the counterparty is obligated to deliver exact index returns, a TRS structure can greatly reduce the potential for tracking error
• Tax Efficient: The TRS used in the Horizons ETFs allows the value of dividends to be reflected directly in the net asset value (NAV) rather than paid out separately as a taxable distribution
How a TRS Works
The following example outlines how a $100 investment in the Horizons S&P/TSX 60TM Index ETF would be invested to gain exposure to its underlying index.
Canadian index ETFs that use a TRS structure do have counterparty risk that generally does not exist with a traditional physical replication fund, however this risk is managed to stay low.
• The counterparties on a the TRS are typically the largest financial institutions in Canada
• The posted collateral for the swap is cash and held on account with the ETF’s custodians
• Units of the ETF can be redeemed at any time with no impairment to the net asset value of the ETF
Counterparty Risk
Counterparty risk only exists if the ETF is in a positive mark-to-market position relative to the notional value of the TRS, and this positive marked-to-market value cannot, in accordance with National Instrument 81-102 governing Canadian mutual funds, exceed 10% of the ETF’s net asset value.
The likelihood of an ETF counterparty, which is a large Schedule 1 Bank, facing financial impairment during a rising Canadian stock market is in our view quite remote considering the prevalence of these institutions in the Canadian stock market.
The table below outlines market conditions in which counterparty risk, if any, would exist and the options available to the ETF to reduce the risk:
The counterparty to the TRS is required to maintain a minimum credit rating equivalent to the following for each applicable rating service: DBRS rating of A, Fitch rating of A, Moody’s rating of A2, and/or an S&P rating of A.
Horizons ETFs is a member of Mirae Asset Global Investments. Commissions, trailing commissions, management fees and expenses all may be associated with an investment in exchange traded products managed by Horizons ETFs Management (Canada) Inc. (the “Horizons Exchange Traded Products”). The Horizons Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. The prospectus contains important detailed information about the Horizons Exchange Traded Products. Please read the prospectus before investing.
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Understanding Total Return Swap