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investor clinic

I love dividends. Nothing brightens my day like a juicy dividend payment or, better yet, a dividend increase from one of the stocks I own.

But dividends also have a dark side: In a non-registered account, they’re taxable (albeit at a lower rate than other income). What’s more, eligible dividends are “grossed-up” by 38 per cent for tax purposes (before the dividend tax credit comes into play), which inflates an investor’s taxable income and can lead to clawbacks in Old Age Security and other government credits and benefits.

Wouldn’t it be nice if there was a way to enjoy the fruits of dividends, without the drawbacks? Well, it turns out there is: It’s called a total return exchange-traded fund.

Total return ETFs trade on a stock exchange just like traditional ETFs, but they have one key difference: They don’t hold any securities directly. Instead, they mirror the performance of an index through an agreement – called a total return swap – with a financial institution, typically a Canadian bank.

The mechanics of the swap are complex, but the important thing is that the financial institution – called the counterparty – is required to deliver the index’s total return, from price changes and dividends, to the ETF provider. No dividends actually change hands; if the stocks in the index rise 6 per cent and dividends contribute an additional 2 per cent, the net asset value of the ETF will rise 8 per cent.

Both sides of the swap agreement get something out of the deal. The counterparty collects a swap fee (in some cases) and earns interest on cash balances. Because the counterparty hedges its equity exposure, it makes money whether the index rises or falls.

For investors, swap-based ETFs offer three main benefits.

First, they provide tax advantages when used in non-registered accounts. Because no dividends are distributed to the ETF holder, there are no taxes to pay and no dividend gross-ups to worry about, either. Taxes are only payable when the units are sold, at which time any capital gains are taxed at half the rate of regular income.

Second, swap-based ETFs have very low costs. The Horizons S&P/TSX 60 Index ETF (HXT), for instance, has a management expense ratio of just 0.03 per cent. HXT can keep its expenses low because it doesn’t have to manage and rebalance a portfolio of stocks and because the counterparty – which gets its own tax benefits from participating in the structure - doesn’t charge a swap fee. However, because U.S. stocks don’t offer the same tax-saving opportunities to the counterparty, the Horizons S&P 500 Index ETF (HXS) pays a swap fee of about 0.3 per cent which, in addition to a management fee of 0.1 per cent, brings the ETF’s total cost of about 0.4 per cent.

A third benefit is that total return ETFs tend to track their underlying indexes closely. HXT has posted a five-year annualized return of 8.49 per cent – virtually identical to the S&P/TSX 60 Index’s total return of 8.54 per cent.

Horizons is the only provider of swap-based ETFs in Canada, and since launching HXT in 2010 the products have become a huge part of its business. HXT, with assets of about $1.75-billion, is now the company’s largest ETF, says Mark Noble, senior vice-president with Horizons ETFs Management (Canada) Inc.

Institutional traders were quick to embrace HXT for its low costs, “but it takes quite a long time for [retail] clients to wrap their heads around how the products work,” Mr. Noble said. “And there’s a bit of a leap of faith, too, that it is going to continue to work, and we’ve shown that it does.”

What about the risks? Dan Hallett, vice-president and principal with Highview Financial Group, points out that, in addition to the possibility that stock prices will fall, products such as HXT expose investors to “counterparty risk − i.e., the risk that the bank with which the ETF enters the swap contract will default on payments owed to the ETF.”

However, the ETF’s total value isn’t at risk − just the return under the current swap agreement. What’s more, because of the way swaps work, “the bank will owe the ETF a payment when stocks are moving up − which would generally not be happening in an economic environment that may cause bank failures,” Mr. Hallett said. “That said, the risk isn’t zero − just very small in my opinion.”

A second risk, he said, is that the government could step in and “kill the swap structure’s tax benefits just like it did to equity-forward structures that many ETFs, closed-end funds and mutual funds used through the 2000s to re-characterize interest and other income to capital gains.”

For his part, Mr. Noble said Horizons pro-actively manages counterparty risk to keep exposure to a minimum. As for the possibility that the rules could change, he called it “extremely unlikely. We’ve had these strategies running for years and we’re not too concerned about it.” Besides, he added, the government still collects plenty of tax when institutional market makers redeem units − an ongoing part of the ETF business – and when clients sell their units for a gain.