Does it matter if your ETF is physical or synthetic?

Here is how to assess whether a synthetic ETF could be right for you.

Most investors in Europe favour ETFs that use physical replication. According to Morningstar data, over 80% of assets in equity ETFs and 95% of assets in fixed-income ETFs are in funds that replicate the performance of the index by holding all, or a selection, of the constituents. The remainder are held in ETFs that employ synthetic replication.

Synthetic ETFs deliver the performance of the index by negotiating a total return swap with a counterparty, usually an investment bank. Investors’ cash is used to purchase a basket of securities, typically known as substitute basket, whose contents may or may not be related to the index the ETF tracks. This substitute basket remains the property of the ETF and its return is passed on to the swap counterparty in exchange for the return of the index.

Synthetic replication has the advantage of offering smooth tracking, but exposes investors to counterparty risk, meaning the risk that the party providing the swap fails to honour its side of the bargain. If that happens, the ETF is left with the contents of the substitute basket, which typically are different from those of the index.

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There is a corner of the market where synthetic ETFs are gaining popularity. Since 2017, the market share of synthetic ETFs tracking popular US equity indices such as the S&P 500 and the MSCI USA has increased and already accounts for one-third of assets invested. This is because synthetic ETFs benefit from a favourable regulatory regime (Section 871(m) of the US Internal Revenue Service Code) that allows for the total return of the index in swap contracts to be calculated free of withholding tax on dividends.

In short, at present a synthetic S&P 500 ETF gets the full return of the index whereas a physical ETF remains liable to pay the withholding tax (15% for Irish-domiciled and 30% in Luxembourg). Over past years, this tax advantage has meant that synthetic ETFs tracking the S&P 500 index have outperformed their physical competitors.

US equity is part and parcel of most portfolios and this is a market where passive funds have consistently beaten active managers over extended periods. According to the Morningstar Active-Passive Barometer study, where we tally up active managers against passive alternatives, only 6.2% of active managers in the US large-cap equity category manage to outperform passive funds over a 10-year period. Said otherwise, if you want to invest in the US equity market, then go passive.

The question for many ETF investors now is: should I go synthetic to benefit from the extra performance? This is not an easy question to answer and ultimately depends on one’s knowledge of financial instruments and attitude to risk.

Under UCITS regulation, the net swap counterparty risk exposure may not exceed 10% of the fund's NAV. Morningstar recently conducted due diligence on the main providers of synthetic ETFs in Europe and we found that all of them apply tighter thresholds than the UCITS rule of 10%, which thus results in lower counterparty risk. In fact, some providers target zero swap counterparty exposure daily. Some ETF providers further diversify counterparty risk by sharing out swap exposure between two or more counterparties.

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Regulators and ETF providers also impose rules on the composition of the substitute baskets. The assets in the basket may not be those of the index, but they will typically be liquid stocks and bonds. Besides, the contents are disclosed entirely and typically updated daily on the providers' websites so that investors always know what assets the fund owns.

Providers of synthetic ETFs have various courses of action if a swap counterparty ceases to fulfil its obligations. They could negotiate a swap with a new counterparty, switch the replication method of the ETF from synthetic to physical or ultimately close the ETF, which would mean selling the contents of the substitute basket and redeeming shareholders.

Here are a few questions that should help you assess whether a synthetic ETF could be right for you.

• Do I understand how swaps work?
• Does the ETF use single or multiple swap counterparties?
• How often is swap counterparty risk exposure reset?
• What assets make up the substitute basket?
• What is the procedure to deal with the default of a swap counterparty?
• Will the assets in the substitute basket be difficult to sell in the event of a counterparty default?

Investors' attitudes to risk are not uniform. Even in possession of answers to all these questions, some investors will decide that synthetic ETFs are not for them, whereas others will be happy to use them. The important thing is to have the information to make that choice.

Jose Garcia Zarate is associate director, passive strategies, manager research, Europe, at Morningstar.