The launch of the first exchange traded fund (ETF) transformed the investment landscape. ETFs brought the twin advantage of pooled investing and trading flexibility along with being a cost-efficient, transparent, and convenient mode for investors to access a variety of investment opportunities. ETFs have grown to become one of the most popular products globally. Over the years, many advanced, innovative, and exotic versions of ETFs have been launched—synthetic ETFs being one of them. Here’s an overview of synthetic ETFs.
Synthetic ETFs can be called the opposite of physical or traditional ETFs. Unlike a physical ETF which buys shares of an underlying index which is being tracked, synthetic ETFs do not hold securities but enter a total return swap with financial institutions that promise to pay the return on the benchmark to the ETF. The two main structures used in synthetic ETFs are funded and unfunded.
Synthetic ETFs are often compared with physical ETFs. While physical assets score over synthetic ETFs in terms of owning physical securities, synthetic ETFs have an edge when it comes to taking exposure to hard-to-access assets (such as crude oil). The synthetic replication method offers advantages in terms of tracking error over physical ETFs, however, counterparty risk adds to the riskiness associated with synthetic ETFs.
To combat the counterparty risk, the swap entered by synthetic ETFs is collateralized with a portfolio of securities to which it has access in case the swap counterparty defaults on its obligations. It should be noted that the securities in the collateral basket are generally different from those of the benchmark referenced by the ETF.
“Hence, the level of collateralization—the market value of the collateral basket—is important to protect investors against losses in case ETF counterparty does not honor the swap contract. If the credit quality or liquidity of the collateral assets is lower than the ETF benchmark assets, this difference could pose additional risks to the ETF investors,” according to FEDS Notes. To minimize any such risks, ETF providers and regulators impose restrictions and issue guidelines around the value and composition of the substitute basket.
Synthetic ETFs were first introduced in 2001 in Europe, and soon became hugely popular, accounting for more than one-third of ETFs there. However, there was a decline in these products in the aftermath of the financial crisis and the euro crisis as regulators such as the Financial Stability Board and IMF issued warning reports that raised concerns over counterparty and liquidity risks. This resulted in a gradual decline in assets under management. In 2010, 46% of assets in equity ETFs and 35% of assets in fixed-income ETFs were held in synthetic funds in Europe. However, by the end of 2020, the number had shrunk to 17% and 5%, respectively.
In comparison to Europe, the U.S. market is comparatively smaller. The primary reason for this was the restriction on the launch of new synthetic ETFs by the U.S. Securities and Exchange Commission; it had to be run by an asset manager who was already sponsoring synthetic ETFs before 2010. According to a Bloomberg report, “In the whole ETF universe, only 1,020 ETFs are synthetic, accounting for approximately 11% of the universe; of that number, 67% are in EMEA, 23% in the Americas and 10% in the Asia-Pacific.”
There has been a renewed interest in synthetic ETFs, especially for European-domiciled U.S. equity synthetic ETFs. This is particularly due to the favorable regulatory taxation regime for specific products. Under the Section 871(m) of the Internal Revenue Code, the use of certain derivatives allows for the total return of the index, i.e., free of withholding tax on dividends as against a withholding tax of 15%-30% for regular ETFs.
The Nasdaq-100, S&P 500, and MSCI World are some of the popular indexes synthetically replicated. In September 2020, BlackRock launched the iShares S&P 500 Swap UCITS ETF. The ETF has $919.83 million as assets under management. In addition, BlackRock has a synthetic ETF tracking the Nasdaq-100, which was launched in 2006 and is dubbed as the iShares Nasdaq-100 UCITS ETF (EXXT). Some of the other popular synthetic ETFs tracking these major indexes are from Invesco, Amundi, Lyxor, and DWS (Xtrackers). In March 2021, NASDAQ-100 Swap UCITS ETF was launched by Invesco.
As both synthetic and physical ETFs continue to co-exist, the preferred choice from an investor’s perspective among the two methods—physical and synthetic replication—would depend on the underlying asset, region, and taxation laws.
Disclaimer: The author has no position in the index or stocks mentioned. Investors should consider the above information not as a de facto recommendation, but as an idea for further consideration. The report has been carefully prepared, and any exclusions or errors in it are totally unintentional. The data related to ETFs and Indexes is as on September 21, 2021.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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