Five months before the 2019 federal budget was announced, Horizons ETFs Management (Canada) Inc. chief executive Steve Hawkins began to hear whispers that the Canada Revenue Agency was going to crack down on tax deferral strategies that were key to more than half the assets in the company’s business.
Mr. Hawkins, along with his legal and senior management team, began planning 10 different scenarios the CRA might propose. Instead, the agency singled out a different tax technique altogether, taking aim at how some investment funds are able to allocate income and capital gains. The proposed legislative changes put Horizon’s clients at risk of triggering taxable distributions after 2019.
It’s the kind of regulatory blow that could kill a company completely. But the following day, Horizons issued a public statement, reassuring investors that the company would find another tax structure for its exchange-traded funds.
“When we first heard the news from the budget, it was disappointing because we had really good sales momentum right up until that point,” Mr. Hawkins said in an interview. “We had raised $500-million in the last six months and now we had a very big undertaking [ahead of us] to make sure we weren’t going to see those assets walk out the door.”
Within two months of the budget announcement, he had engineered a plan to retool and relaunch the investment funds into a new mutual fund corporate-class structure.
“This was the single biggest change in the history of the firm, and I was confident that we were going to be able to make a decision that would allow us to continue to offer these products with the tax efficiency that investors enjoyed,” Mr. Hawkins said.
“But we had our hands tied in that we couldn’t publicly announce anything until we got regulatory approval, while nervous clients were asking us what we were going to do.”
Now, more than 18 months later, the company’s quick pivot has led to a surge in investor demand for the revamped, tax-efficient funds, putting Horizons back on the industry leaderboard with more than $5.7-billion in sales for 2020 as of Oct. 31.
The Canadian ETF market has grown to about $232-billion across 38 different asset managers after seeing a major influx of funds in 2020, according to data by National Bank Financial Inc. Horizons is the country’s fourth-largest ETF manager, with $15.2-billion in assets. For the first five months of 2020, the company dominated ETF sales in Canada, bringing in $4.2-billion in new funds – ahead of ETF giants Bank of Montreal and RBC iShares.
Over the past decade, ETFs have grown in popularity because they offer investors the ability to passively track major stock indexes for a fraction of the cost of mutual funds. However, distributions from these investments are generally taxable, which can reduce an investor’s potential after-tax return.
To help prevent that, Horizons launched its first total return index (TRI) funds in 2010, which typically don’t directly hold securities but provide the same performance as a widely followed stock market or fixed income index through what’s known as a “total return swap” agreement with a financial institution.
The investments grew in popularity among investors in non-registered accounts because no dividends or interest are received and no income taxes are payable until the units are sold, at which time the investor’s total return is taxed advantageously as capital gains. (Capital gains are taxed at a lower rate than dividends for high-income earners.)
While Horizons is the only ETF provider in Canada to use such a tax strategy, the tactic is commonly deployed by asset managers throughout Europe and the United States. But in 2019 the CRA surprised the investment industry when it took aim at some derivative investments that “inappropriately” allocate capital gains or losses in a way that defers taxes or converts income into capital gains, which are taxed at a lower rate.
Horizons had to quickly halt the launch of several new TRI funds. Mr. Hawkins also shelved half a dozen planned ETF funds that had not launched yet, and the entire company spent six months with “all hands on deck” for the overhaul. This involved redesigning 15 existing TRI funds, as well as 29 other products that use derivatives to track commodities, including the company’s suite of leveraged ETFs, which use complex contracts to magnify returns.
“We were also playing damage control because many of our competitors were using the budget announcement to create false or misleading propaganda about our total return ETFs,” Mr. Hawkins said. “Fighting through the plethora of misinformation and disinformation to update our clients and advisers became a full-time job for our sales team.”
The company raced to get the corporate-class funds set up by the end of 2019. A corporate-class structure is set up like a company and can hold multiple investments under one roof. It allows the fund to share expenses and spread profits and losses from the different fund portfolios across the underlying funds in a way that’s more tax-efficient for unitholders.
“This was really the best option for Horizons because they can aggregate the income and expenses of its corporate-class funds – each a separate share class of its newly formed mutual fund corporation – on a single tax return,” said Dan Hallett, vice-president and principal of Highview Financial Group and an investment expert who has covered the industry for decades. “Accordingly, for any mutual fund corporation to have some tax efficiency, it helps to have some funds (or classes) that are income-oriented and others that are not under the same corporate umbrella, so that expenses and losses of some classes offset the income and gains of other classes.”
The pivot has paid off for Horizons, with investors now flocking to the refurbished TRI funds. Of the $5.7-billion in net sales for the first 10 months of the year, 98.4 per cent went into TRI strategies. In February, the company launched three new TRI funds – including the Horizons S&P/TSX Capped Composite Index (TSX: HXCN), which received $1-billion in seed capital from CIBC World Markets, the highest amount ever invested in a Canadian fund.
“This change has undoubtedly been successful for Horizons and has attracted a significant amount of assets from both retail and institutional investors into the TRI funds,” said Daniel Straus, vice-president of ETFs and research at National Bank Financial. “This was a really big undertaking for a company to make this move, and they did it by the book, which required quite a bit of paperwork not only by Horizons but also by fund accountants and every investor.”
Mr. Straus says that while the corporate-class structure is unlikely to be on the CRA’s radar for further tax rule changes, the current regulatory treatment of mutual fund corporations cannot be guaranteed. In the past 15 years, Ottawa has shut down the tax benefits of income trusts, changed the tax treatment of synthetic funds and has forbidden further tax-free “switch” trades among share classes.
“Over the years, the Ministry of Finance has repeatedly set its sights on the asset management industry,” Mr. Straus said. “The 2019 budget is the latest example of regulatory interventions that may continue in the coming years.”
With a file from Brenda Bouw
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