By Dan Hallett on October 5, 2010
What’s in it for National Bank?
This has been an often-asked question since HXT was launched. Previously, funds using forward or swap contracts have been used to obtain exposure to a specific fund, often bond portfolios (i.e. to effectively ‘convert’ interest income to capital gains). These derivatives typically cost 0.3% to 0.4% per year.
The swap used for HXT is a more common structure that has associated tax benefits for the counterparty. HXT’s prospectus notes that they are not paying National Bank to structure the swap. And I confirmed that this is standard practice – not a circumstance unique to the BetaPro-National Bank relationship.
Recall that HXT tracks the S&P/TSX 60TMTotal Return Index (i.e. price changes + full reinvestment of dividends). In hedging its swap exposure, the counterparty invests in the index stocks.
Accordingly, it receives dividends which are effectively tax-free because they’re Canadian-source dividends. But the payment under the swap, which includes an amount equal to the dividends, is fully deductible. This tax arbitrage is effectively National Bank’s compensation for structuring the swap and taking on the tracking error risk. Counterparties do not enjoy a similar tax benefit with swaps covering bonds or foreign stocks because both types of investments generate fully taxable income.
Are HXT investors fairly compensated for credit risk?
This is perhaps the more interesting question. As noted in my previous post, the tax benefits to HXT investors are arguably not that large since eligible dividends are taxed at a similar rate as capital gains for taxable income much above $70,000 annually in Ontario (varies by province).
So the primary benefit of HXT’s structure is its improved tracking of, let’s say, 0.02%per year and fee savings of 0.08% to 0.10% annually. That 10 to 12 basis points is effectively the compensation to HXT investors for assuming the credit risk of the swap. But, it’s important to understand exactly what’s at risk.
Total return swaps usually exchange only the returns not the notional value (or total investment). So, only the return payment is at risk in the event of the counterparty’s failure. According to National Instrument 81-102 (see page 23 of this link), the mark-to-market value of a swap held with any single counterparty cannot exceed 10% of a fund’s net asset value (NAV) for more than 30 days. In other words, up to 10% of HXT’s net assets could be lost if National Bank of Canada fails. And we can look to the credit default swap (CDS) market to determine if HXT investors are fairly compensated for assuming this credit risk exposure.
While I was unable to obtain a CDS quote for National Bank, I was able to get quotes for a basket of U.S. banks. One of them, Wells Fargo, has Warren Buffett’s vote of confidence given that it’s one of Berkshire Hathaway’s holdings. A five-year CDS on Wells Fargo was recently quoted at 106 basis points. But Wells Fargo’s credit ratings (AA-) are stronger than those of National Bank (A). And Goldman Sachs, which was recently quoted at 155 basis points on the CDS market, has only slightly weaker credit ratings than National Bank .
Even if we assume that National Bank of Canada’s CDS quote is equal to Wells Fargo’s 106 basis points, the implied cost of credit protection is roughly equal to HXT’s cost advantage. This is calculated by multiplying the maximum credit risk exposure of 10% by the cost of the 106 basis points for credit protection (i.e. 10% x 106 basis points = 10.6 basis points). In other words, if HXT wanted to protect investors against the possible failure of National Bank of Canada, it could buy protection for the equivalent of about 0.106% annually. Doing so would cause its cost advantage to vanish. Judging by credit ratings, however, the cost may well exceed HXT’s 10 to 12 basis point advantage.
Some investors and advisors will naturally gravitate toward simpler structures. Others will embrace complexity for the sake of greater efficiency and potentially better tracking. Indeed, Ontario Teachers’ Pension Plan held nearly $200 million in equity total return swaps as of two years ago. Personally, I would favour BMO’s ZCN for its low fees and simpler structure if I wanted to index large cap Canada – which, by the way, I do not.
But HXT’s launch gave birth to an interesting irony. When people began trading BetaPro’s leveraged and inverse ETFs, they appeared to do so without a thorough read of the ETFs’ prospectus. (Incidentally, BetaPro came under so much scrutiny that they commissioned some educational pieces – including one by yours truly prior to joining HighView – to make sure that investors and advisors understood the implications of daily tracking.)
Yet the launch of HXT, a much simpler product, sparked widespread scrutiny of its prospectus by journalists, bloggers, competitors, etc. looking for something wrong. It’s refreshing but ironic nonetheless. Despite the fact that I wouldn’t buy it, HXT doesn’t appear to be all that scary. While HXT may launch a Canadian-style price war, it’s a price war just the same and ETF investors could benefit from this increased competition.