National Post (National Edition)
ETF showdown
Now that global equity markets are rallying to new highs, many investors are getting off the sidelines and back into the game. More often than not in Canada, the preferred point of re-entry is the country’s premier large-cap benchmark, the S&P/TSX 60 index. In this regard, exchange-traded-fund enthusiasts have two options: the iShares S&P/TSX 60 Index Fund and the Horizons S&P/TSX 60 index ETF. Both ETFs are well regarded by analysts and over the past two years have provided similar returns. But XIU and HXT, as they are respectively better known, are far from identical products. They are structured in significantly different ways and they provide widely contrasting risk/reward profiles for investors. Here, the Financial Post’s David Pett presents two visions of how to emulate the same thing and what investors need to know about each.
Being the oldest exchange-traded fund in Canada has its advantages, but the
iShares S&P/TSX 60 Index Fund, also the most widely held ETF in the country, has more going for it than just longevity, said Mary Anne Wiley, head of iShares Canada.
“Being first doesn’t mean you are going to be the leader for two decades,” she said. “Investors continue to like it because it is the cleanest, most efficient, safest way to access the top 60 names in the country.”
XIU is a physical ETF so it directly invests in the securities that make up the TSX 60. Stocks held by the fund are weighted exactly as they are in the index and are also rebalanced in corresponding fashion. “What you see is what you get,” Ms. Wiley said. “It is an almost perfect replication of the index. As it goes up and down in the market, you will see a corresponding move in the fund.”
XIU provides several advantages for investors, she added. For one, there is less potential for counterparty risk than with synthetic funds because the securities are held by the fund and not a third party.
It also tends to involve relatively minor due diligence on the part of investors, because it is a less complicated structure to understand, and it is a very liquid investment.
“It is one of the most actively traded securities on the exchange, which holds incredibly liquid stocks,” Ms. Wiley said. “The combination is what makes it so efficient.”
The ETF does have some disadvantages when compared with its synthetic competition, chiefly a higher management fee and less tax efficiency. It also tends to have a higher tracking error.
Another potential worry is the general practice of securities lending among physical ETF providers, which adds some additional risk, but Ms. Wiley believes this concern is mostly unfounded.
“It’s important to remind people that securities lending done responsibly is actually a good and important feature of capital markets,” she said. “Within the context of iShares and XIU, we take a conservative approach and hold collateral levels above what is required. We want it to be safe. “
Ultimately, Ms. Wiley believes investors need to decide whether the benefit of a certain structure outweighs the burden.
She said synthetic ETFs can be a great way to access some of the more obscure and/or expensive areas of the global market, including commodities and emerging markets. But she believes physical ETFs are the way to go in Canada and other highly liquid and transparent jurisdictions.
“Why crawl through a skylight if you can walk through the door,” she said.
Horizons S&P/TSX 60 Index
ETF was launched in 2010 to give investors a different and cost-effective way of gaining exposure to the country’s largest stocks.
“There was no advantage in bringing to market another ETF that does exactly the same thing as XIU,” said Howard Atkinson, CEO of Horizons Exchange Traded Funds Inc. “We could have done it, and offered a management fee a few basis points cheaper, but that wouldn’t have been too compelling for Canadian investors.”
Instead, HXT gains exposure to the TSX 60 using a basic derivatives contract known as a total return swap or TRS for short. A TRS is an agreement whereby one or more large financial institutions are obligated to deliver the total return of an underlying asset in exchange for the interest earned on a collateralized cash deposit, which is held by a custodian. In the case of HXT, there is just one counterparty, a major Canadian bank.
“With swap-based ETFs, the unitholder’s cash investment is held in a collateral account that earns interest,” Mr. Atkinson explained. “The collateral, plus or minus any gains or losses on the underlying index, are returned to the investor when the ETF units are sold.”
He said the benefits of the structure include lower costs and better tracking of the underlying index, which can lead to better performance since the provider doesn’t have to manage a portfolio of physical stocks.
TRS ETFs also eliminate taxable distributions, so investors who hold HXT in a non-registered account will only be subject to taxation when they sell the ETF at a gain, Mr. Atkinson said.
Despite these advantages, many investors are concerned about the direct counterparty risk that exists with HXT, but not with XIU. Since a financial institution is obligated to deliver the returns of the underlying index, it must be financially able to do so, which introduces some credit risk in the process.
But Mr. Atkinson said HXT’s credit risk is very low given national regulations that limit the positive mark-tomarket value of total return swaps to 10% of the ETF’s net asset value.
“It is difficult to imagine a scenario in which the TSX 60 would appreciate significantly when, simultaneously, a major Canadian financial reached a level of financial impairment that it couldn’t meet its basic debt obligations,” he said. “It’s not impossible, but the statistical likelihood is very low.”
While HXT was initially slow to accumulate assets, growth has been more substantial since September. “If you can accept the very low probability of a counterparty default for the very high probability of higher returns, that’s the tradeoff here,” Mr. Atkinson said. “Clearly, many investors are seeing the benefit.”