What’s a total return swap?

June 24, 2016 | Last updated on September 15, 2023
6 min read

A total return swap (TRS) sounds complicated, but at its core, it’s a way to provide perfect tracking and tax efficiency for clients.

A TRS is based on an agreement between two parties: the total return receiver and the counterparty (often a bank). The receiver agrees to pay the counterparty a set rate, and the counterparty agrees to pay the receiver the total return of a reference asset (e.g., an equities index or a basket of bonds).

In other words, the two parties swap returns, with the receiver guaranteed the returns of the reference asset (less fees) without owning it.

TRSs have been common for decades between institutional investors and Canadian banks as counterparties, says Steve Hawkins, co-CEO and CIO at Horizons ETFs in Toronto.

Now, they’re available for retail investors in ETF format. “It wasn’t substantially different for banks to bring that trade into a retail investment fund wrapper,” he says. (In Canada, only Horizons offers these synthetic ETFs. In the U.S., ProShares and Direxion offer them.)

Dan Bortolotti, an investment advisor at PWL Capital in Toronto, gives an example of how a TRS ETF might work.

“Say an ETF tracks the S&P/TSX 60 […], but it doesn’t hold the stocks of any of those companies. […] The counterparty has the obligation to deliver to the ETF provider the returns of that index. So if that index returns 8% next year, the counterparty has to pay the ETF provider 8%. Effectively, it gives investors the exact same exposure as owning the stocks directly.”

That’s perfect tracking—before fees, says Marjorie Skolnik, director of equity derivatives at National Bank in Montreal (National Bank acts as a counterparty).

3 advantages of a TRS ETF

  • Tax efficiency
  • Perfect tracking (before fees)
  • Low fees

Perfect tracking

The perfect tracking has won over Terry Shaunessy, president and portfolio manager at Shaunessy Investment Counsel in Calgary, who uses synthetic ETFs, including TRS ETFs, for his clients’ portfolios.

“The great thing about a swap is it gives you the total return of whatever asset you’re looking for,” he says.

For example, even if you own the same stocks as an equity benchmark, you won’t get the same total return unless dividends are always reinvested immediately. In practice, it takes time to reinvest dividends, and that can drag returns. And the timing of reinvested dividends is “even more of an issue now given how volatile markets in single stocks are,” he says, because the price of blue-chip stocks can move “3% to 5% in a day.”

In contrast, TRS ETFs are convenient because dividends are automatically reinvested, and reliable because of perfect tracking, he says. One risk, as with any index product, is that the reference asset return is negative. Shaunessy recognizes this risk, but says in the long term, “big blue-chip equities rise by the rate of growth in earnings over time.”


TRS ETF fees are usually below 50 basis points.

Here’s how they affect returns. Consider an S&P 500 total-return-swap ETF with a management fee of 15 basis points and a swap fee of 30 basis points, for a total of 45. “If next year the S&P 500 returns 10%, the investor should expect to receive 9.55%,” says Bortolotti.

There are also ETFs without swap fees. Hawkins says that’s possible when, for instance, banks can take advantage of favourable tax treatment on Canadian dividends.

Bortolotti says even though fees are tiny, they give counterparties “a very small but risk-free rate of return.”

Tax advantages

Besides perfect tracking and low fees, the other advantage for investors is tax efficiency.

Says Skolnik: “In terms of holding [TRS] ETFs in nonregistered accounts, it’s favourable because the distributions are reinvested and not taxed” until investors sell, at which point investors pay the more favourable capital gains tax.

One potential exception is a swap-fee-free ETF, says Bortolotti.

“You could make a reasonable argument that holding such an ETF in a tax-sheltered account is a good idea, because you can still get extremely low cost and low tracking error in a way that you would not necessarily get with a plain-vanilla ETF.”

Once you add in a swap fee, however, all bets are off.

“There is absolutely zero benefit in paying a 30-basis-point swap fee on a synthetic ETF in an RRSP, because you’re getting zero tax advantage. There are much cheaper options,” says Bortolotti. (Plain-vanilla ETFs usually set you back 10 basis points or fewer.)

Hawkins says eliminating taxable distributions by using synthetic ETFs that track a U.S. total return index produce significant tax savings by avoiding U.S. withholding tax and potential estate taxes.

While the tax benefit for nonregistered accounts is an important consideration, says Bortolotti, an investor’s risk and market exposure should be considered first, as with any investment.


ETFs are governed by NI 81-104, which permits 10% maximum counterparty exposure within a fund. “What that means is as soon as the mark to market exceeds 10% over 30 days, the two counterparties would agree to reset the swap, bringing the mark-to-market below the 10% limit. Because of that feature, the maximum risk the ETF would have is never greater than 10% of its value,” says Skolnik.

And that 10% would be at risk only if a counterparty went bankrupt or fell into financial distress, she adds. Skolnik suggests the advisor review the swap documentation prior to purchase.

“You’re not going to lose your original principal” unless the reference asset’s return is negative, says Bortolotti. “You are potentially going to lose a portion of the gains. […] I don’t see counterparty risk as an enormous concern, but it is one you need to be aware of.”

Neither does Shaunessy, expressing confidence in the creditworthiness of Canadian banks. What concerns Bortolotti is structural risk—inherent in all investment products.

For instance, tax rules could change, he warns. If the government decides it’s losing too much tax revenue, it could disallow swaps, and investors would be required to liquidate.

In such a case, “you’re not going to lose any money […], but […] you could be forced to realize a very large capital gain,” Bortolotti says.

He cites income trusts as an example of tax-favoured structures previously targeted by the government.

But, says Hawkins, “we realize income inside the trust; there is no recharacterization of income here,” as there was when CRA targeted forward agreements in 2013.

Bortolotti also stresses the importance of understanding a swap’s underlying asset. With the S&P 500, for example, liquidity isn’t a problem. But if the swap’s underlying asset class were a high-yield bond index, says Bortolotti, “it’s got a bunch of illiquid bonds from companies that might be really hard to sell […]. If you’re going to use a swap, make sure the swap is tied to liquid assets and not some exotic, illiquid asset like high-yield bonds or an invented index—[for example,] a commodity hedge fund index.”

Shaunessy agrees, saying swaps should be used “to buy basic building blocks” for a portfolio. “You can get the Canadian bond index swap, you can get U.S. 7-10 year treasury swaps, you can get S&P 500 swaps, TSX composite swaps. […] Concentrate on asset allocation and total asset set-up.”

The only thing keeping Shaunessy, who invests solely in ETFs, from using TRS ETFs for an entire portfolio is that there’s only one manufacturer of those products in Canada. “It’s not good risk management to put too many assets with one service provider,” he says.

Shaunessy’s last tip: beware foreign exchange. “If the Canadian dollar all of a sudden turns around and goes up to $0.80, you’re going to have an FX that will depress the rate of return on swaps with U.S. dollar returns. Be sure of your view of where you think the Canadian dollar is going.”

Table 1: Save on taxes with TRS ETFs
ETF tax comparison: Canadian price return index vs. U.S. price return index vs. total return index
ETF 1: TSX ETF 2: S&P 500 ETF 3: TRS (synthetic ETF)
Investment $1,000 $1,000 $1,000
Dividend tax rate (highest marginal rate in Ontario for 2016) 39.34% 53.53% n/a until sold at a capital gain
Index total return (including dividends) 7% 7% 7%
Index yield 2.5% 2.5% 2.5%
Distributions $25 $25 $0
Year-end market value before taxes $1,070 $1,070 $1,070
Tax on dividends $9.84 $13.38 $0
Market value after taxes $1,060.16 $1,056.62 $1,070
Total return lost to tax on dividends 14.06% ($9.84 ÷ $70 × 100%) 19.11% ($13.38 ÷ $70 × 100%) 0%
Upon liquidation at year end ETF 1: TSX ETF 2: S&P 500 ETF 3: TRS (synthetic ETF)
Original cost of investment $1,000 $1,000 $1,000
Market value when sold 1,060.16 1,056.62 $1,070
Realized capital gain $60.16 $56.62 $70
Capital gains tax rate (highest marginal rate in Ontario for 2016) 26.76% 26.76% 26.76%
Tax payable $16.10 $15.15 $18.73
After-tax proceeds from sale $1,044.06 $1,041.47 $1,051.27
Total return lost to all taxes (dividends and capital gains) 37.06% ($25.94 ÷ $70 × 100%) 40.76% ($28.53 ÷ $70 × 100%) 26.76% ($18.73 ÷ $70 × 100%)

For simplicity, MERs and withholding taxes are not considered.

by Michelle Schriver, assistant editor of Advisor Group.