Sylvain Barrette: What are synthetic ETFs?

Florence Cremer: There are two methods to replicate the performance of an index such as the S&P 500 or the CAC 40: physical replication and synthetic replication.  Physical replication involves the ETF issuer directly investing in the assets that compose the target index, such as buying-–almost--all the shares in the S&P 500.

Synthetic replication is different; the ETF manager does not directly invest in the index’s assets but delegates the index replication to a counterparty using derivative products called total return swaps (TRS). The swap aims to replicate the performance of the index as closely as possible.

In return, the ETF issuer buys and holds a basket of assets, which don’t necessarily match the index, to serve as collateral or guarantee. The performance of this collateral basket is exchanged via the swap for the index’s performance.

Why have they become relevant?

Synthetic ETFs are particularly relevant in several scenarios. They are pertinent for accessing assets or geographic regions that are difficult or costly to hold physically, such as emerging markets.

They also offer potential cost efficiency for obtaining certain assets. A major advantage highlighted is their potential benefit regarding the US withholding tax on American stock dividends. Unlike physical ETFs that buy US stocks that are subject to a withholding tax of 15% (applicable when a tax convention applies) or 30% for non-US investors, synthetic ETFs can be exempted.

This exemption, under IRS regulation 871(m), applies to swaps tracking qualified US index components (like S&P 500, NASDAQ 100, MSCI USA), allowing the dividend to be paid in full via the swap. This exemption holds irrespective of whether the ETF is domiciled in Ireland or Luxembourg. In addition, the domiciliation of the counterparty is also not relevant for the rule to apply.

Are synthetic ETFs more efficiently replicating than physical ETFs?

Another key advantage of synthetic replication is its precision in tracking the index performance. While physical replication always has some degree of tracking error, synthetic replication using swaps allows the tracking error to be significantly reduced, often approaching 0%. This high tracking precision is considered a major strength.

The synthetic ETFs are more efficient, but at what cost?

Synthetic ETFs come with challenges and risks. The primary risk is counterparty risk, as the ETF's performance relies on the counterparty fulfilling its swap obligations.

This risk is mitigated by Ucits regulations in Europe, which provide protection mechanisms for investors. Ucits rules mandate specific requirements for the collateral, demanding it be of high quality, liquid and diversified, and its value must be at least equal to the ETF’s value, often requiring an additional margin, or overcollateralisation, typically around 105%.

Are we finding synthetic active ETFs in the market?

Given the discretionary management, they are much more difficult to replicate synthetically and are rare.

Are synthetic ETFs gaining ground in Europe?

Looking at market trends in Europe, physical replication remains dominant, accounting for approximately 80% of equity ETFs and 95% of bond ETFs. This suggests an investor preference for simpler, more transparent products.

When investors invest in physical replication, they know exactly in which stock the ETF will invest. As synthetic ETFs are based on derivative products, there is always an issue of transparency at play. The perception of structured products having a negative image since the global financial crisis.

Synthetic ETFs experienced strong growth in the 2000s and 2010s, particularly for complex exposures, but growth may have slowed slightly in recent years, possibly due to stricter Ucits rules.

Nevertheless, future growth is anticipated due to increasing awareness of their advantages, like tax efficiency on US stocks and tracking precision, aided by better information, education and tools available to investors.

Are the synthetic ETFs easier to set up for new players?

Despite being more cost-efficient, setting up a synthetic ETF is more complex than a physical ETF. Yet promoters must have a critical mass to offer a physical ETF on the MSCI World, given the broad exposure in the index.

What is your role as distributor?

Swissquote, as a distributor, feels comfortable offering synthetic ETFs due to the protections afforded by regulations like Ucits regarding collateral. Our role is to ensure that the promoters provide all necessary documentation (product objectives, risk profile, etc.) to investors and that the products are suitable as per their risk profiles.

Whether a retail investor may or may not have access to synthetic ETFs depends on the definition of the product by the promoter. While potentially more complex to set up, synthetic ETFs might be more accessible for new players aiming to offer broad, global exposures compared to managing the vast physical asset base required for a large index such as the MSCI World.

Will that growth come largely from professional and institutional investors?

A significant proportion of synthetic ETFs are utilised by professional and institutional investors. The potential for synthetic ETFs to outperform physical ones comes primarily through cost optimisation and tax efficiency over the medium to long term.

Who are the major players in Europe?

Amundi is the European leader in synthetic ETFs and also a pioneer in this replication method (via the acquisition of Lyxor Asset Management). Xtrackers is also a major player in synthetic ETFs in Europe.  iShares as well as Invesco are offering them.

ETFs that are listed on the exchanges that we offer will be referenced on our opened platform. We are more familiar with the product range of players with whom we have partnerships such as Amundi.