Would You Take This Risk?

[Smith1776]

As you guys know, I'm a fan of using balanced funds in place of the stock/bond/cash portion of the PP. (At least for people outside the U.S., who really need some international exposure.) I've got a nuanced question for all of you brilliant people on the forum. I'm going to try and make this as succinct as possible so as not to drown readers in minutiae.

In Canada there is a company called Horizons which offers so-called total return ETFs. These are synthetic vehicles that don't actually hold any stocks or bonds. Rather, they track a benchmark by relying on a counterparty to deliver the total return of the target index. Since the fund doesn't technically hold any stocks or bonds, it makes no dividend or interest distributions. They are essentially accumulating units that will only trigger tax liabilities in the form of capital gains when sold.

HOWEVER, the federal government in 2019 cracked down on these vehicles by closing some loopholes that these ETFs relied on. Horizons fired back by switching to an alternative structure (so-called corporate class structure) which delivers all of the same benefits.

So, here's the question: in a taxable account, would you take the risk of the government further cracking down on these structures in order to receive the benefit of commuting all dividend and interesting income into capital gains? The savings can be substantial, but if the government disallows them in the future, the funds may be forced to dissolve, and unit holders might end up realizing a big capital gains liability all at once.

Here's a link to one of the funds I'm talking about.

https://www.horizonsetfs.com/ETF/HCON

[Libertarian666]

As you guys know, I'm a fan of using balanced funds in place of the stock/bond/cash portion of the PP. (At least for people outside the U.S., who really need some international exposure.) I've got a nuanced question for all of you brilliant people on the forum. I'm going to try and make this as succinct as possible so as not to drown readers in minutiae.

In Canada there is a company called Horizons which offers so-called total return ETFs. These are synthetic vehicles that don't actually hold any stocks or bonds. Rather, they track a benchmark by relying on a counterparty to deliver the total return of the target index. Since the fund doesn't technically hold any stocks or bonds, it makes no dividend or interest distributions. They are essentially accumulating units that will only trigger tax liabilities in the form of capital gains when sold.

HOWEVER, the federal government in 2019 cracked down on these vehicles by closing some loopholes that these ETFs relied on. Horizons fired back by switching to an alternative structure (so-called corporate class structure) which delivers all of the same benefits.

So, here's the question: in a taxable account, would you take the risk of the government further cracking down on these structures in order to receive the benefit of commuting all dividend and interesting income into capital gains? The savings can be substantial, but if the government disallows them in the future, the funds may be forced to dissolve, and unit holders might end up realizing a big capital gains liability all at once.

Here's a link to one of the funds I'm talking about.

https://www.horizonsetfs.com/ETF/HCON

Absolutely not.

But not entirely because of the risk of government intervention.

Who guarantees the counterparty?

[Smith1776]

Absolutely not.

But not entirely because of the risk of government intervention.

Who guarantees the counterparty?

Thanks for the reply, Libertarian666.

There are two counterparties responsible for delivering the return of the index: CIBC and National Bank of Canada. The law requires that counterparty banks that deliver the index return must be Schedule I institutions with a minimum AA credit rating.

Also, I forgot to mention one thing that probably made the instrument sound more risky that it deserves to. The cash that investors use to buy units of the fund is deposited in an interest bearing cash account. That interest is sent to the Schedule I bank in exchange for the index return. If the fund structure collapses, the cash can be sent to investors. If the value of the index exceeds the cash value of the fund by more than 10%, the counterparty bank must deposit cash into the fund. So, theoretically, even in a worst case scenario, the fund should be able to recover 90.9% (100% divided by 110%) of its value to investors if the structure collapses.

The CEO of Horizons points out that it's unlikely that the index would be over 90.9% of all time highs if a major bank in Canada were failing though. So the actual losses due to fund mismanagement would likely be nil. I thought he had a fair point there.

But yeah, basically I'm just finding that these are extremely interesting instruments. Even if I don't invest in them, they're still fascinating.

[Libertarian666]

Absolutely not.

But not entirely because of the risk of government intervention.

Who guarantees the counterparty?

Thanks for the reply, Libertarian666.

There are two counterparties responsible for delivering the return of the index: CIBC and National Bank of Canada. The law requires that counterparty banks that deliver the index return must be Schedule I institutions with a minimum AA credit rating.

Also, I forgot to mention one thing that probably made the instrument sound more risky that it deserves to. The cash that investors use to buy units of the fund is deposited in an interest bearing cash account. That interest is sent to the Schedule I bank in exchange for the index return. If the fund structure collapses, the cash can be sent to investors. If the value of the index exceeds the cash value of the fund by more than 10%, the counterparty bank must deposit cash into the fund. So, theoretically, even in a worst case scenario, the fund should be able to recover 90.9% (100% divided by 110%) of its value to investors if the structure collapses.

The CEO of Horizons points out that it's unlikely that the index would be over 90.9% of all time highs if a major bank in Canada were failing though. So the actual losses due to fund mismanagement would likely be nil. I thought he had a fair point there.

But yeah, basically I'm just finding that these are extremely interesting instruments. Even if I don't invest in them, they're still fascinating.

In general I use the old rule of thumb that a greater number of moving parts means more failure modes.
I'm sure HB would have agreed with me.

[Smith1776]

In general I use the old rule of thumb that a greater number of moving parts means more failure modes.
I'm sure HB would have agreed with me.

I tend to agree.

[Smith1776]

For anyone who comes across this thread, and is interested in this total return derivative structure, Ben Felix of PWL Capital has made a wonderful video that explains this seemingly convoluted investment methodology.

https://youtu.be/-CCXHSv1Ld8

[dualstow]

You only asked for "brilliant" people, but I will chime in that I am a fan of holding assets directly, or nearly directly. I've got treasuries from brokerage houses and only an occasional nibble of TLT/EDV; gold is almost completely physical now and I can't wait to dump the final ETF shares at breakeven; stocks are definitely not something I want to abstract too far. I'm fine with the dividends and pay zero taxes on them.

So +1 on a minimum of moving parts.

[Smith1776]

You only asked for "brilliant" people, but I will chime in that I am a fan of holding assets directly, or nearly directly. I've got treasuries from brokerage houses and only an occasional nibble of TLT/EDV; gold is almost completely physical now and I can't wait to dump the final ETF shares at breakeven; stocks are definitely not something I want to abstract too far. I'm fine with the dividends and pay zero taxes on them.

So +1 on a minimum of moving parts.

I can get onboard with that. I think I'm going to do research on a "least abstraction" variant of the PP here in Canada!