Total Return Index ETFs

Cost and Tax-Efficient Index Exposure

Horizons ETFs believes that investors should be able get passive index exposure as cost and tax-efficiently as possible. That’s the idea behind our family of Total Return Index ETFs (“TRI ETFs”), which are index-tracking ETFs that use an innovative investment structure known as a Total Return Swap to deliver index returns in a low cost and tax-efficient manner.

How does a TRI ETF work?

Unlike a physical replication ETF that typically purchases the securities found in the relevant index in the same proportions as the index, a TRI ETF is a synthetic structure that never buys the securities of an index directly. Instead, the cash portion of the ETF is put into an interest-earning cash account. The TRI ETF then provides the investor with the total return of the index through entering a Total Return Swap agreement with one or more counterparties, typically large financial institutions, which will provide the ETF with the total return of the index in exchange for the interest earned on the cash deposit. Any distributions which are paid by the Index constituents are reflected automatically in the net asset value (NAV) of the ETF.

As a result, the investor only receives the total return of the index, which is reflected in the ETF’s unit price, and is not expected to receive any taxable distributions directly. This means that an investor is only expected to be taxed on any capital gain that is realized if, and when, holdings are sold.

In the Total Return Swap, in exchange for providing the total return of the Index, the counterparty receives any interest earned on the portfolio cash and, in some cases, an additional swap fee depending on the asset class. TRI ETFs offered by Horizons ETFs that invest in foreign securities or fixed income securities will be charged a swap fee. None of the TRI ETFs that invest in Canadian equities have a swap fee associated with their Total Return Swap.

Example of $100 invested in a TRI ETF

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Benefits of a TRI ETF

1. Lower Management Fees and Operating Costs. The ETF’s exposure is created through a synthetic index-tracking process that does not require extensive portfolio management, which allows the manager to reduce the management fee. Transaction costs are also lower because rebalancing isn’t executed by the ETF, but by the counterparty to the swap agreement. This is not the case with a physically replicated ETF, which has higher transaction costs since it is directly responsible for constant rebalancing due to dividend distributions and capital appreciation on individual stock constituents in the underlying the index.

2. Reduced Tracking Error. When an ETF physically replicates an index, it typically mandates that regular distributions, dividends or interest from the underlying securities be accrued during the year and paid out on a scheduled distribution date. As a result, the cash held within the structure does not participate in the index returns, creating a drag on the performance of the ETF. This, combined with the ETF’s transaction costs from rebalancing, contributes to tracking error. With a swap structure, these issues are essentially eliminated since the counterparty delivers the total return of the index.

3. Increased Tax Efficiency. No distributions are received by the ETF using the TRI structure; therefore, no income is expected to be received by the ETF investors. Investors get the full pre-tax, total return value of the index, which includes the full pre-tax value of any distributions by the index constituents as reflected by the Index, which are “reinvested” into the NAV of the ETF.

Tax Implications for TRI ETFs - Illustrative Examples Only

TRI ETFs should not be subject to:

• Taxable distributions as a result of the flow-through of index constituent distributions
• Foreign withholding tax
• U.S. estate tax

The following examples below show the potentially significant tax advantage of holding TRI ETFs that track the total return version of a bond or equity index.

Tax Implications for Holding a TRI Bond ETF in Non-Registered Accounts

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For Illustrative Purposes Only. The above illustrative example highlights the expected after-tax performance benefits of holding a TRI Bond ETF versus another Canadian domiciled physically replicated Bond ETF in a non-registered account, assuming both ETFs earned/reflected a net 2% interest income and track the exact same universe of bonds. This example does not take into account any fees or expenses of the ETFs, or any commissions, fees, or expenses that would be associated with the purchase or sale of units of the ETFs. Both ETFs are held by an Ontario resident investor in the fourth highest tax bracket, who would have a marginal tax rate of 46.41%* in 2016. The example does not contemplate the sale of the ETF units or any tax liability that would result. It also assumes no change in the market value of the index constituents.

Tax Implications for Holding a TRI Canadian Equity ETF in Non-Registered Accounts

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For Illustrative Purposes Only. The above illustrative example highlights the expected after-tax performance benefits of holding a TRI Canadian Equity ETF versus another Canadian domiciled physically replicated Canadian Equity ETF in a non-registered account, assuming both ETFs earned/reflected a net 2% dividend and track the exact same universe of stocks. This example does not take into account any fees or expenses of the ETFs, or any commissions fees or expenses that would be associated with the purchase or sale of the ETF units. The example also does not contemplate any sale of the ETF units or any tax liability that would result. Both ETFs are held by an Ontario resident investor in the fourth highest tax bracket, who would have a marginal tax rate of 46.41%, and a effective tax rate of 29.52%** on eligible Canadian Dividends, in 2016. The example does not contemplate the sale of the ETF units or any tax liability that would result. It also assumes no change in the market value of the index constituents.

Total Return Index ETF Mechanics

One factor that is associated with a TRI ETF structure, as opposed to a physically replicated ETF structure, is counterparty risk. Generally, TRI ETFs limit exposure of their assets to counterparties to a mandated maximum of 10%. However, it’s important to note that many physically replicated ETFs lend their securities, which also introduces some counterparty risk.

The counterparty to a TRI ETF is the institution taking on the contract to swap the income stream (in Canadian dollars) that it will receive from the ETF, in exchange for the total return of the index to be delivered to the ETF. Some of the relevant components of Horizons TRI ETFs are as follows:

• Horizons ETFs are only exposed to counterparty risk when the TRS is in a marked-to-market net gain position – the current level of the Index is greater than the index level at the time at which the TRS was entered into and the counterparty owes money to the ETF. Horizons ETFs posts current levels of this marked-to-market exposure on its website on each Horizons TRI ETF product page on a monthly basis
• Counterparty risk is actively managed and reduced through the subscription and redemption process; it is rare that a Horizons TRI ETF is in a situation where the counterparty risk of the ETF exceeds 10% of the NAV; if this happens, it must be reduced within the next 30 days
• The daily marked-to-market value of the exposure of TRI ETFs to any one counterparty is generally not allowed to exceed 10% of the NAV of the ETF, in accordance with National Instrument 81-102. The daily marked-to-market value of a swap is based upon the daily performance of the reference index, which is calculated on a total-return basis
• The counterparty to a swap in a Horizon’s TRI ETF must maintain the following minimum long-term debt credit rating: A (DBRS), A (Fitch), A2 (Moody’s), A (Standard & Poor’s). The counterparties used by Horizons TRI ETFs are all Canadian Schedule 1 Banks

Horizons Family of TRI ETFs

Ticker ETF Name Management Fee1 (%) Swap Fee (%)
HXT Horizons S&P/TSX 60™ Index ETF 0.07* 0.00
HXH Horizons Cdn High Dividend Index ETF 0.10 0.00
HXQ Horizons NASDAQ-100® Index ETF 0.25 0.375
HXS Horizons S&P 500® Index ETF 0.10 0.30
HXE Horizons S&P/TSX Capped Energy Index ETF 0.25 0.00
HXF Horizons S&P/TSX Capped Financials Index ETF 0.25 0.00
HBB Horizons Cdn Select Universe Bond ETF 0.09 0.15
HTB Horizons US 7-10 Year Treasury Bond ETF 0.15 0.05
HTH Horizons US 7-10 Year Treasury Bond CAD Hedged ETF 0.15 0.10
HSH Horizons S&P 500 CAD Hedged Index ETF 0.10 0.30
HXX Horizons Euro Stoxx 50® Index ETF 0.17 0.30
HXDM Horizons Intl developed Markets Index ETF 0.20 0.30
 

1 Before applicable sales taxes.
*Annual management fee rebated by 4bps (0.04%) to an effective management fee of 3bps, or 0.03%, effective as of October 1, 2015 until at least September 30, 2018.

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Horizons ETFs is a Member of Mirae Asset Global Investments. Commissions, management fees and expenses all may be associated with an investment in exchange traded products managed by Horizons ETFs Management (Canada) Inc. (the "Horizons Exchange Traded Products"). The Horizons Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. The prospectus contains important detailed information about the Horizons Exchange Traded Products. Please read the relevant prospectus before investing.

The Horizons Exchange Traded Products consist of the Horizons Index ETFs ("Index ETFs"), 2x Daily Bull and -2x Daily Bear ETFs ("2x Daily ETFs"), Inverse ETFs ("Inverse ETFs"), VIX ETFs (defined below) and active ETFs. The 2x Daily ETFs and certain other Horizons Exchange Traded Products use leveraged investment techniques that can magnify gains and losses and may result in greater volatility of returns. These Horizons Exchange Traded Products are subject to leverage risk and may be subject to aggressive investment risk and price volatility risk, which, where applicable, are described in their respective prospectuses. Each 2x Daily ETF seeks a return, before fees and expenses, that is either 200% or -200% of the performance of a specified underlying index, commodity or benchmark (the "Target") for a single day. Each Index ETF or Inverse ETF seeks a return that is 100% or -100%, respectively, of the performance of a Target. Due to the compounding of daily returns, a 2x Daily ETF's or Inverse ETF's returns over periods other than one day will likely differ in amount and possibly direction from the performance of their respective Target(s) for the same period. The Horizons Exchange Traded Products whose Target is the S&P 500 VIX Short-Term Futures Index™ (the "VIX ETFs"), one of which is a 2x Daily ETF and one of which is an Index ETF, as described in their prospectus, are speculative investment tools that are not conventional investments. The VIX ETFs' Target is highly volatile. As a result, the VIX ETFs are not generally viewed as stand-alone long-term investments. Historically, the VIX ETFs' Target has tended to revert to a historical mean. As a result, the performance of the VIX ETFs' Target is expected to be negative over the longer term and neither the VIX ETFs nor their Target are expected to have positive long term performance. Investors should monitor their holdings, as frequently as daily, to ensure that they remain consistent with their investment strategies.

*The indicated rates of return are the historical annual compounded total returns including changes in per unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. The rates of return shown in the table are not intended to reflect future values of the ETF or returns on investment in the ETF. Only the returns for periods of one year or greater are annualized returns.