BlackRock has launched a synthetically replicated S&P 500 ETF in a significant policy U-turn that sees the asset management titan lend credibility to an ETF replication structure it previously eschewed, often vocally.
BlackRock has launched its first synthetically replicated equity ETF after years of shunning the fund structure.
Synthetic ETFs provide exposure to their reference index not by physically holding the underlying index securities but by entering into a swap agreement with a counterparty, usually an investment bank, to receive the performance of the index.
The popularity of the synthetic structure declined sharply following the global financial crisis due to concerns over counterparty and liquidity risks – a 2011 survey conducted by Morningstar found that 90% of respondents indicated they were “somewhat” or “very” concerned about synthetic ETFs.
Some of these concerns were arguably whipped up by ETF issuers whose product line-ups comprised solely or mostly physically replicated products (many of which, incidentally, were at the time lending out portfolio securities and keeping much of the proceeds for themselves) and by traditional fund managers who saw it as an opportunity to attempt to taint the ETF industry.
BlackRock was noted for its championing of physical ETF replication. In 2011 its then Head of iShares in Europe, Joseph Linhares, told the FT that, “ETFs started out as transparent, liquid, simple, vehicles but some have gone to opacity. We need to get back to full transparency across all the range of ETF products.” Larry Fink, the firm’s co-founder and CEO, regularly told investors and commentators that swap-based ETFs lacked transparency and risked damaging the industry.
As a result of all this, many issuers, such as Lyxor and Deutsche Bank, among others, converted swathes of synthetic ETFs to physical replication. This was despite the swap-based structure delivering many noteworthy advantages and ignoring the fact that these products were often over collateralized, in some cases with higher quality collateral than the constituents of the target index, and/or had multiple swap counterparties.
In recent years, however, the tide of criticism against synthetic ETFs has waned as investors have become reacquainted with the benefits of the structure’s inherent tax advantages in certain circumstances.
These tax advantages primarily relate to dividends. Most notably, non-US investors are hit with withholding tax on income received from dividends – 15% for Irish-domiciled funds and 30% for Luxembourg funds. As synthetic ETFs do not own the exact underlying securities (substitute baskets typically hold non-distributing US stocks and/or non-US securities) and owing to the way the swap arrangements are configured and treated from a regulatory perspective, they are not liable for this tax, leading to immediate performance enhancement.
According to market analysis by Invesco, which offers a mix of physical and synthetic products, the firm’s synthetically replicated S&P 500, MSCI USA, and MSCI World UCITS ETFs have each outperformed the average of their largest physical competitors by 0.24%, 0.31%, and 0.12% respectively over the 12 months to the end of August 2020.
When looking over the past three years, these figures climb to 0.71%, 0.64%, and 0.18%, underscoring the long-term relative outperformance potential of some synthetic products.
Another advantage of synthetic ETFs is that they typically offer a lower tracking error compared to their physically replicated counterparts, although this benefit is most pronounced when the fund targets illiquid stocks such as emerging market equities.
The low tracking error offered by synthetic products was brought into focus during the Covid-19 market crisis with tracking errors for physical MSCI World ETFs doubling to 0.10% between 31 January and 30 April 2020. In contrast, synthetic ETFs generally maintained their lower volatility relative to the market throughout this period.
These advantages have contributed to synthetic ETFs gaining a greater market share in certain asset class segments in recent years. The $10.7bn Invesco S&P 500 UCITS ETF (SPXS LN), for example, has attracted over $2.4bn in net inflows over the past year compared to net outflows of $1.4bn for the $38.3bn iShares Core S&P 500 UCITS ETF (CSPX LN) over the same period.
In performing its volte-face, BlackRock will no doubt argue that the ETF industry and the wider financial infrastructure have become structurally more sound in the ensuing years and that levels of transparency and disclosure have improved while ETF investors have become more sophisticated. To be fair, much of this is probably true. Nonetheless, it demonstrates that commercial considerations – namely a company’s bottom line – will always influence an argument, as indeed it did back in 2011 and 2012.
The fund
The iShares S&P 500 Swap UCITS ETF has listed on the London Stock Exchange in pound sterling (I500 LN), on Xetra in euros (I500 GY), and on Euronext Amsterdam in US dollars (I500 NA).
JP Morgan and Citi will act as swap counterparties with more investment banks expected to enter the fold in the future.
The ETF’s collateral will consist solely of non-dividend paying S&P 500 equities, helping to allay any concerns that the structure might be unsuitable in the event of a default by a swap counterparty.
It comes to market with $100 million in assets under management and matches the 0.07% expense ratio offered by BlackRock’s physically backed S&P 500 ETF.