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There are Canadian ETFs from Horizon which operate as “total return swaps,” including HXS (tracks S&P 500) and HXT (tracks the total return of the S&P/TSX 60).

From a 2011 CanadianCouchPotato blog post “Understanding swap-based ETFs”:

If you invest $1,000 in HXT, Horizons places your money in a cash account that earns the prevailing short-term interest rate. Horizons then enters into a total return swap with another financial institution—in this case, National Bank. This “counterparty” agrees to accept the interest on the cash account in exchange for delivering the return of the S&P/TSX 60 Total Return Index. (This includes not only the price change of the stocks, but also all of the dividends.) The upshot is that even though you do not actually own any of the stocks in the index, you have exactly the same market exposure as someone who does.

Due to this structure, HXT tracks its index extremely closely, and it’s also extremely tax-efficient because it never distributes either dividends or capital gains. (The Canadian government has not been thrilled by this tax strategy, leading to some 2019 changes, but it nevertheless continues to track its index closely without distributing gains.)

There are a few things that I don't understand about the structure and risks of an ETF constructed in this way…

What’s in it for the counterparty?

Horizons places your money in a cash account that earns the prevailing short-term interest rate. This “counterparty” agrees to accept the interest on the cash account in exchange for delivering the return of the S&P/TSX 60 Total Return Index.

According to CCP's follow-up interview with Horizon, the counterparty (National Bank of Canada) was earning ~1.3% interest on the deposited cash in 2011. Meanwhile, they had agreed to deliver the total return of the index (which now stands at ~7% over the lifetime of HXT) which they did by holding the underlying stocks as a hedge.

Apparently, the Canadian-source dividends are tax-free for the counterparty bank while the swap payments are deductible, so the counterparty was coming out well ahead… getting both the interest on the cash, as well as a tax benefit for the swap payments (“dividend tax arbitrage”).

Now how about for HXS (the ETF that tracks the S&P 500)? For that one, the dividends are not Canadian-source, so the counterparty isn’t getting the tax arbitrage benefit.

Does this explain why HXS carries a “swap fee” of up to 0.30%, whereas HXT has none?

How does HXS track its index so well?

HXS (the S&P 500 ETF) has an MER of 0.10%, and a swap fee of “up to” 0.30%, so you'd expect it to lag its index by ~0.40%, which is pretty substantial.

And indeed, the trailing returns shown on Horizon’s site line up with that:

HXS trailing returns from Horizon

But, on the other hand, if I plot the returns of HXS on Morningstar vs. Vanguard’s VFV (which has a MER of 0.09%), a “conventional” Canadian ETF that tracks the S&P 500, then HXS appears to be tracking VFV to within 0.10%/year:

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How does HXS track its S&P 500 index so closely?

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What’s in it for the counterparty?

Horizon pays to use NBC's balance sheet. "[T]he interest on the cash account" makes it sound like some token amount when it's really OIS + some spread, which more than covers NBC's costs.

How does HXS track its index so well?

I'm not sure I'd call 45bp vs a total return of ~11% "substantial" (5Y), as far a the chart is concerned. There should be no tracking error other than fees, since it's fully replicated using the underlying.

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  • There should be no tracking error other than fees Well, what I'm reacting to is that HXS appears to be tracking its index even closer than its fees would suggest; it's actually better than Vanguard VFV over 10 years. I wonder how they're doing it.
    – Dan Lenski
    Commented Mar 28, 2023 at 3:21
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    @DanLenski is it though? If I click on your link, it shows "growth of 10,000": 45,062 (index) vs 43,769 (hxs)
    – 0xFEE1DEAD
    Commented Mar 28, 2023 at 13:56
  • Also, there's a footnote that says "All data based off of NAV except where noted"
    – 0xFEE1DEAD
    Commented Mar 28, 2023 at 13:57
  • Yeah, this is a good observation. I get conflicting answers about its performance depending on exactly which research site I consult, and how I do the comparison. I do think it's notable that HXS is perfectly matched to Vanguard VFV (a well-run Canadian SP500 fund with MER of 0.09, and a conventional index-tracking method).
    – Dan Lenski
    Commented Apr 1, 2023 at 4:45

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