Using ‘synthetic’ ETFs to track a market has some cost benefits – but is not without risks.
Exchange-traded funds (ETFs) are cheap and cheerful ways to track different stock market indices or a selection of companies that fit into a certain theme.
Listed on the stock exchange, most physically own the basket of goods they track, normally updating their positions four times a year when the underlying index rebalances.
This is how most ETFs function, with the most popular in Britain – such as the Vanguard and iShares S&P 500 ETFs which have more than £35 billion invested between – all physically owning their shares.
But there is another way of tracking the performance of major stock markets: using financial contracts to replicate the returns of shares, including their dividends. These are called “synthetic” ETFs. We explain how they work and the advantages and disadvantages of owning them.
How do they work?
The ETF provider (a company such as BlackRock, Vanguard or WisdomTree) enters into an agreement with a financial institution, usually a bank. The bank is called the “counterparty”.
The agreement takes the form of “swap”. contracts and essentially this means that the counterparty (the bank) agrees to pay the ETF provider the total return of the pre-decided index.
Emphasis should be placed on the total return here – it means that the counterparty pays both the share price appreciation and dividend payments of the index.
So, if the chosen index is the FTSE 100, the counterparty pays the ETF provider the amount the FTSE 100 has appreciated by, as well as the equivalent of all the dividends paid out in that period by companies on the index. The ETF would typically receive the precise index performance, minus a fee for the swap contract.
In contrast, physical ETFs involve buying the components of an index and trading when the underlying index rebalances. Performance deviates from the index due to trading fees, how the ETF handles dividends, and any revenue received from securities lending.
When could synthetic be better?
Invesco, a fund manager that offers physical and synthetic ETFs, says that synthetic ETFs are most effective when they track the “gross” return of a market. The gross return is the true return of an index before taxes are calculated, such as those on dividends.
In the US, company dividends are taxed, meaning that physical replication of an index comes with extra costs compared with a synthetic approach.
As a result, a synthetic ETF domiciled in Ireland can benefit from an additional 15% of dividend values, compared with a physically replicated ETF also domiciled in Ireland, according to Invesco.
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In the UK and Europe, synthetic ETFs have similar other advantages. In the UK, physically buying shares involves paying stamp duty, and in France and Italy there is a similar “Financial Transaction Tax”. Synthetic ETFs do not have to pay these taxes as they are not buying the underlying shares, resulting in a saving for investors.
Invesco points out: “If the swap counterparty (usually a bank) buys the constituents of the index to hedge the derivative contract it writes with the ETF, the bank would generally be exempt from those same taxes.”
Global ETFs bring the European and US tax advantages together, in theory leading to savings for investors.
Another advantage of a synthetic ETF is that it can offer exposure to assets that are difficult and expensive to trade, such as commodities, or companies listed in mainland China.
However, synthetic ETFs add on a “swap” fee alongside the management fee to cover the costs of replicating an index. This can eat into any performance increases from harnessing tax advantages.
What are the risks?
The main risk is “counterparty risk” - or risk that the bank offering the derivative will not be able to honour the contract due to its own internal problems. Fund managers can limit this risk by using multiple counterparties (Invesco sometimes uses six).
During the 2008 financial crisis, some banks did fail, with many more coming close to the brink, showing how real counterparty risk can be.
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But it is important to remember that financial meltdowns are rare, while banking regulation has improved significantly. So long as the ETF provider uses reputable counterparties, the risk is low.
Dzmitry Lipski, head of funds research at interactive investor, said: “Our approach is to keep it simple for retail investors, therefore we prefer physically backed ETFs to gain low-cost access with low tracking error to many mainstream asset classes/indices.
“As such, in most cases, retail investors don’t even need to consider synthetic ETFs and making extra efforts to understanding more complex derivative structures, taking on more risks such as counterparty risk, and potentially paying higher fees.
“However synthetic ETFs may be a great option where investors would like to access more specialist/alternative asset class markets. For example, commodities, where investing through futures and swap contracts is the most popular and least costly approach. The availability of various commodity indices makes this strategy attractive to investors. The WisdomTree Enhanced Commodity ETF (LSE:WCOB) has been on our Super 60 listed of recommended funds since May 2021.”
Has performance actually been better?
The Invesco S&P 500 ETF (synthetic), which charges 0.05% in management fees, has beaten the iShares Core S&P 500 ETF and Vanguard S&P 500 physical ETFs, which cost 0.07%. It has returned 230% over a decade compared with 224% and 226% for the physical ETFs.
Invesco’s global synthetic tracker, Invesco MSCI World Ucits ETF, has failed to beat iShares’s physical version (iShares Core MSCI World Ucits ETF) since launch. It has returned 156% since July 2014 compared with 157.5% for the physical version. Its management fee is 0.19% versus 0.2% for the iShares ETF
The Invesco FTSE 100 Ucits ETF, which is synthetic and charges 0.09% in management fees, has returned 216% since launch in 2009 compared with 223% for the iShares Core FTSE 100 Ucits ETF, which charges 0.07% in management fees.
Swap fees could be to blame for the lower returns from synthetic ETFs. Invesco adds a 0.15% swap fee to its FTSE 100 tracker and a 0.04% to its S&P 500 tracker, for example. These are to cover the costs of the financial contracts used to simulate the returns of an index.
How do I know if my ETF is synthetic?
The surest way to tell is to look at the ETFs “Key Investment Document”, or KID. These are documents that ETF providers are legally required to provide if they want to sell their products to UK investors. On interactive investor, they can be found in the ‘documents’ section, just under the performance chart, on the page of any ETF.
Within the KID, there is a section called ‘objective and investment policy’. This should tell you whether the ETF is physical or synthetic.
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So, for example, if we look at the KID of the Lyxor FTSE 100 ETF (LSE:L100) it becomes clear that it uses a synthetic strategy to replicate the performance of the FTSE 100. Under its objective and investment policy, it states: “The fund seeks to achieve its objective via indirect replication by entering into an over-the-counter swap contract.”
In contrast, if you look at the KID of the Vanguard FTSE 100 UCITS ETF (LSE:VUKE), you can tell that it is a physical ETF. In its objectives and investment policy section, it says the fund’s aim is to “track the performance of the index by investing in all constituent securities of the index in the same proportion as the index”.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.