Wednesday, 29 September 2010

Canadian Large Cap Equity ETFs: BetaPro's HXT Joins the Fray

A significant new player - Horizons BetaPro S&P/TSX 60 Index ETF (TSX symbol: HXT)- has come onto to the scene of Canadian Large Cap Equity ETFs since our review of last December. How does the new entrant, which started trading on September 15th, stack up against the others - BMO Dow Jones Canada Titans 60 Index ETF (ZCN), iShares S&P/TSX 60 Index Fund (XIU) and Claymore Canadian Fundamental Index ETF (CRQ) - and how have the others changed since December?

HXT's Unique Product Design
Instead of buying and holding the companies in its index like the other ETF providers, the Horizons manager of HXT has set up a contract, called a Total Return Swap, with the National Bank under which the the bank agrees to provide HXT with the exact return on daily basis of the S&P/TSX 60 Index, including the value of any distributions the constituent companies pay out. This has a number of implications and consequences when HXT is compared to the other ETFs:

1) Counter-party Risk - What Happens if National Bank Cannot Pay?
This has generated a lot of controversy (e.g. this Financial Webring forum thread) and misunderstanding about whether HXT is inherently much more risky due to its structure. Blogger WhereDoesAllMyMoneyGo provides an excellent summary and explanation of exactly how HXT works, the bottom line of which is that HXT does not have appreciably more counter-party credit risk due to the Swap form of construction. See also Horizon's clarification posted on the Canadian Capitalist blog.

2) Dividends/Distributions get automatically reflected in the asset value of HXT as if they were being reinvested completely and instantaneously. This can be good or bad for the investor, depending on his/her needs and circumstances. Whereas ZCN and CRQ offer an optional Dividend Reinvestment Program (DRIP), there is no choice but to reinvest with HXT. The Total Return index tracking makes this happen in effect as part of the design. That's good if the investor is building a portfolio and wishes to reinvest but not so if you wish to receive the cash. XIU is inferior on this factor since iShares offers no DRIP.

3) Deferred Capital Gains vs Immediate Dividends - HXT does not, as noted above, actually receive dividends. Instead their value is incorporated within the share price and is only realized when the investor sells the shares, which means capital gains are deferred. Nor does HXT pay out any dividends. There will be no annual tax slips issued. In a registered account, it doesn't matter since there is no annual tax liability, only income tax to pay when a withdrawal is made from the account. Within a taxable account the absence of annual taxable distributions can make a very large positive difference in the end total after taxes since the dividends can grow and compound on a tax-deferred basis. But there is a caveat - it does not help low income investors (up to about $40,000 taxable income in Ontario - see this table in since they do not pay any income tax on eligible dividends (and that's what constitutes 90% or more of distributions from the S&P/TSX60) - see our previous post Three Reasons to Love Dividends for more on how this works.

4) Income Tax Liability Risk - Though HXT is designed and expected by Horizons to continue indefinitely, in which case the only tax liability of the investor is upon selling the HXT shares for a capital gain, the termination of the Swap would cause the gains, both the price rise and the dividends, accumulated within HXT to be distributed for tax purposes as ordinary income to HXT shareholders at the time. After many years that could be a very large amount. A shareholder who had bought in much later would become liable for tax on TSX60 capital gains and dividends generated in all the years before he or she bought in. In contrast, the other ETFs distribute cash received on a quarterly basis, so any tax liability is dealt with each year and there is no overhanging risk of potential future liability beyond a quarter.

5) Management Expense Ratio - HXT is the new low cost leader with an outstanding 0.07% MER, less than half its closest rivals ZCN and XIU. Horizons claims that there are no other expenses other than 13% HST tax on the MER, which will add another 0.01% to the total.

6) Assets, Liquidity, Tracking Error and Premium/Discount to NAV - The bigger and more actively traded an ETF, the better for the investor to get efficient pricing versus the Net Asset Value (NAV) of the underlying holdings and tight bid-ask spreads that lower the difference between buying and selling prices. ZCN has made the greatest progress into a very competitive second place in terms of asset size (increasing its asset size more than ten times its size from our first review, to a hefty $526 million in total assets). ZCN is still far behind the market leader XIU, which gained more than $1.9 billion in asset size and which has maintained the smallest bid-ask spread. CRQ more than doubled in asset size. New entrant HXT has started with a small initial stake of $50 million but its trading volumes have been amazingly high at several million shares per day, indicating the heavy presence of day traders and institutional investors. Such large increases across the board reflect the growing popularity of index ETFs. Asset size growth from the gain in value of the TSX 60 would only account for about 8.7%. ZCN and CRQ are very similar with bid-ask spreads higher than XIU's, but they are still quite low. HXT's trading volume would suggest its bid-ask spread will be similar too.

Interestingly, HXT breaks the mold on tracking error and it almost surely will be the best on that dimension. Since its value is mathematically calculated to follow the S&P/TSX 60 Index, it should have only the under-performance caused by its MER fee cost, which is the lowest. XIU has its higher 0.17% MER plus reduction to due to transaction costs, re-balancing costs and portfolio optimization costs, together which amounted to 0.02% annually over the past decade, or a total under-performance of 0.19% per year. It may not seem like much difference but it all adds up as XIU returned 81.02% in the last ten years while the Index gained 84.52%.

7) Fund Diversification - ZCN, XIU and HXT share a very similar allocation amongst economic sectors. CRQ's looks very lopsided with a much higher concentration in Financial Services (45% of total assets) and much less in Materials and Energy. Offsetting this is the fact that it has a lower concentration in individual companies - the top ten holdings are only 42% in CRQ vs 45-46% for the others and in the top twenty-five, there is also a much lower concentration. Whether CRQ's portfolio is considered better or worse boils down to a judgement of its fundamental indexing approach compared to the cap-weighted approach, as we discussed in Different and Better (?) Ways to Invest in the Broad US Equity Market.

CRQ has slightly out-performed the other ETFs over the past year as the chart below from Google Finance shows. CRQ's approximate 0.8% higher price gain on the chart does not include the fact that XIU and ZCN had about a 0.4-0.7% higher dividend yield, so the net difference is only 0.1 to 0.3%.

Summary Comparison Table (click on it for larger image)

Bottom Line - a Best Fund?
It's a tough call. All these ETFs are solid choices, none is clearly bad, nor is any a winner across all factors.
  • XIU offers the cheapest trading and best liquidity, but there is no DRIP and its fees are beaten by both ZCN and HXT.
  • ZCN offers second lowest fees and an optional DRIP but unknown tracking error.
  • HXT offers offers outstandingly low fees, automatic reinvestment for those who want it and tax-deferral in taxable accounts but there is the niggling worry about the Swap and potential future bad consequences.
  • CRQ has given better returns and claims it can continue to do so, along with offering the best account features like the DRIP, Systematic Withdrawal Plan and Pre-authorized chequing contributions, but it has a much higher MER and a portfolio very concentrated in Financials.
You choose!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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