By Dan Hallett on September 18, 2010
Most financial journalists in Canada charge that the Canadian investment fund industry lacks the kind of price competition we often see in the U.S. industry. This is true. But like the people, Canadian investment fund price wars exist though they’re a little tamer. Interestingly, the latest launch by Horizons BetaPro raises other questions.
The print and online media quickly picked up on the launch of Horizons BetaPro S&P/TSX 60TM Index ETF (HXT/TSX) since the new ETF, which sports annual fees of 0.08%, was billed as Canada’s cheapest ETF. And in BetaPro’s ad campaign for the new product, HXT was held out as the first example of true direct price competition among Canadian ETFs because it’s the first incidence of two competing ETFs tracking the identical index. While it’s been more than a decade, we have seen this kind of price competition before.
Past price competition
In the late 1990s, mutual fund companies began launching index funds. TD Asset Management was the leader in Canada, having launched its index funds in 1985. But in October 1998, Altamira launched its family of index funds, which sported MERs of 0.53% annually. A year later, RBC Asset Management launched its family of index funds with fees matching those of Altamira. By late 1999, TD launched the series-e units of its index funds, with MERs of 0.3% to 0.5%, thereby under-cutting all other index mutual funds.
The launch of BMO index ETFs marked the first real level of price competition among TSX-traded ETFs. HXT’s introduction simply raises the game but its synthetic structure may attach strings to its lower fees.
Credit risk
HXT does not invest in stocks directly to track the S&P/TSX 60 Total Return Index, choosing instead to track the index via a total return swap with National Bank. (Note that National Bank owns a stake in its affiliate, AlphaPro, and is the counterparty to BetaPro’s leveraged and inverse ETFs.)
HXT will hold money market instruments while National Bank will hold the basket of stocks making up the S&P/TSX 60 Index. The swap is basically a legal contract requiring HXT to pay National Bank the return on its money market instruments; and requiring National Bank to pay to HXT the total return on its stocks.
In the case of National Bank’s failure, HXT’s assets would be safe but the return on those assets – i.e. the index total return – would be at risk of not being paid to the fund. In that kind of scenario there could be other negative implications but as far as the swap is concerned, only the ‘returns’ are swapped not the notional value.
Horizons BetaPro has played down a scenario including National Bank’s failure. To be fair, this is a very small probability event in my view. But it’s one of those scenarios that has a small probability but a potentially significant cost if it ever happened. HXT’s investors are being compensated for this small risk exposure in two ways.
First, despite comments by at least one competitor to the contrary (see Jon Chevreau’s blog), the use of swaps or forwards is generally accepted as being able to legally ‘convert’ all forms of income to capital gains. Given that large cap ETFs are generally pretty efficient, the size of this benefit is questionable.
Second, HXT’s expected 0.08% MER is about half of the cost of its nearest competitor (or 10 basis points cheaper than XIU). This price difference is effectively what HXT investors are being compensated to take on this credit risk.
As I reviewed HXT’s prospectus, I wondered if investors would accept the complexity and small credit risk that comes with HXT in exchange for 8 to 10 basis points of fee savings. Personally, I would probably prefer the plain vanilla version for such a small fee difference. But it will be worth getting greater clarity on whether HXT and its investors are fairly compensated for credit risk exposure – an issue I will address in a future post.
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