Horizons BetaPro has announced that it is introducing the Horizons BetaPro S&P/TSX 60 Index ETF (HXT) that seeks to replicate the performance of the S&P/TSX 60 Index (Total Return) for a headline-grabbing Management Fee of just 7 basis points (0.07%). HBP says that it will bear all other expenses except the sales tax. Assuming the ETF ends up paying the full 13% HST, the all-in MER of the fund should weigh in at just shy of 8 basis points. The new ETF will be significantly cheaper than the iShares S&P/TSX 60 Index Fund (XIU), which charges a management fee of 15 basis points (0.15%) but remains one of the largest and most liquid ETFs available to Canadian investors wanting broad exposure to our equity markets (FD: I own XIU).

At first blush, the new ETFs much lower cost sounds very attractive compared to competing products. But unlike XIU, which invests in and holds the securities that make up the underlying index, HXT plans to use derivatives such as total return swap agreements to gain exposure to the index. In my opinion, the use of derivatives makes HXT an unsuitable core Canadian equity holding for the following reasons.

Counterparty Risk

Investors in HXT are taking a credit risk on the payments that the ETF expects to receive from its counterparties. If the counterparty (The Globe and Mail reported that the initial counterparty is National Bank ) becomes bankrupt, unitholders will not have any recourse against its assets but will have an unsecured claim against the counterparty. Therefore, in the event of a counterparty default, investors in HXT will see a decline in the value of their investments independent of any changes in the value of the S&P/TSX 60.

Swap Fees

According to the prospectus, the ETF will not initially make any fee payments to the counterparty to the swap agreement. But these agreements may be amended in the future and expenses may be incurred for the swap transactions. Swap fees can easily erase any MER advantages that HXT may currently have.

Unclear Tax Treatment

An investor in XIU receives ongoing income in the form of dividends. In a taxable account, an investor will incur tax liability on the dividends but qualified dividends receive favourable tax treatment. Due to its low expected turnover, investors in XIU will face little in the way of ongoing capital gains taxes. It is hard to determine from the prospectus whether HXT, which employs derivatives, can be expected to offer better after-tax returns than XIU.

Bottom line

Horizons BetaPro is going to garner a lot of headlines for launching what it calls Canadas Lowest Cost ETF. The stated management fee of 7 basis points (0.07%) is half that of XIU. While that sounds very attractive, HXTs financial engineering isnt what you could term simple and easy-to-understand. The counterparty risk alone, though very low, may be sufficient reason for those investors who simply want broad exposure to Canadian stocks to avoid this ETF.