Investment research house Morningstar has published a review of synthetic ETFs amid renewed interest from European investors, particularly those seeking exposure to mainstream US equity indices.

Jose Garcia-Zarate, Associate Director, Passive Strategies Research at Morningstar.

The report, Spotlight on Synthetic ETFs in Europe, aims to provide investors with up-to-date knowledge to make informed choices.

Jose Garcia-Zarate, Associate Director, Passive Strategies Research at Morningstar, commented: “Even if circumscribed to a specific market exposure such as US equities, synthetic ETFs are again becoming a topic of discussion in Europe.”

He added: “Using synthetic ETFs is ultimately a matter of personal preferences and attitudes to risk.”

Physical/Synthetic market share

The report highlights how the split in assets under management between physical and synthetic ETFs in Europe has experienced a massive shift in the past decade in favour of physical replication. In 2010, 46% of assets in equity ETFs and 35% of assets in fixed income ETFs were held in synthetic funds; however, at the close of 2020, that market share had shrunk to just 17% and 5%, respectively.

Morningstar notes that the declining popularity of synthetic ETFs, which deliver the performance of an index through the use of total return swaps, has been driven primarily by concerns over counterparty risk – the possibility that the party providing the swap fails to honour its obligation.

While synthetic ETFs overall remain a minority option in Europe, there has been increased usage of the structure for mainstream US equity exposures – the market share of synthetic ETFs tracking the S&P 500 and MSCI USA indices, for example, has increased ten percentage points since 2017 to around 30%.

This trend reflects investors becoming reacquainted with the inherent tax advantages of the synthetic structure in certain circumstances. In particular, 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 contrast, physically replicating US equity ETFs remain liable to pay the withholding tax – 15% for Irish-domiciled funds and 30% for Luxembourg funds.

Synthetic replication models

There are two models currently used by European ETF providers to track an index synthetically: the unfunded swap model, by far the most common, and the funded swap model.

In the unfunded swap model, the ETF manager uses cash from investors to buy a basket of securities – the substitute basket – from the swap counterparty, which commits to deliver the performance of the index (typically adjusted for a swap spread) in exchange for the performance of the securities held in the substitute basket.

The substitute basket must comply with UCITS regulations on asset type, liquidity, and diversification. The assets in the substitute basket remain the property of the ETF and are held in a segregated account at a custodian. Counterparty risk is actively managed in that swaps are marked-to-market regularly and UCITS requirements ensure that the swap is reset whenever counterparty exposure approaches 10%.

In the funded swap model, the ETF manager transfers investors’ cash to a swap counterparty in exchange for the index performance (adjusted for a swap spread) plus the principal at a future date. The swap counterparty posts collateral assets which must also comply with UCITS regulations and be kept in a segregated account with a third-party custodian.

UBS is currently the only European ETF issuer adopting this model, and in its case, the legal title of the collateral basket is transferred, meaning that the collateral is treated as the property of the fund.

Risks of synthetic ETFs

Morningstar notes that synthetic ETFs typically offer superior tracking errors. If the swap counterparty goes out of business, however, the ETF is left with the substitute basket which typically differs from the index it is tracking. Until a new contract is in place, the ETF will effectively deliver the return on the substitute basket, leading to a temporary increase in tracking error.

In the case of a counterparty default, the ETF provider could switch replication from synthetic to physical. Here again, investors will be exposed to temporary tracking error until the transition is completed, while trading costs and the risk of the substitute basket’s realizable value falling short of ETF assets are further factors to consider.

Risk management

Morningstar points out that synthetic ETF providers have developed practices that help to significantly reduce the risks described above.

All ETF issuers on which Morningstar conducted due diligence apply tighter reset triggers than the UCITS rule of 10%, resulting in lower counterparty risk, with some providers targeting zero swap counterparty exposure daily. From an investor’s risk perspective, ETFs that reset swaps daily offer the highest protection, as the counterparty risk that investors are exposed to is restricted to just that day’s movements in the index and substitute basket.

Morningstar notes that most ETF providers now diversify risk by sharing out swap exposure between two or more counterparties. This practice has greatly reduced risk compared to a decade ago when most ETF providers used a single counterparty which would typically be their own parent investment bank.

Substitute baskets currently used by ETF issuers are typically made up of high-quality assets – developed market large-cap equities and bonds from issuers with an investment-grade credit rating. ETF providers can, however, impose their own criteria and there may be substantial differences in the type, size, liquidity, region, and overall credit quality of the underlying contents, making it imperative that investors assess these risks. According to Morningstar, disclosure has improved considerably over the past decade with substitute baskets typically displayed and updated daily on the providers’ websites.

Morningstar notes, however, that the transparency of swap costs remains an area that needs improving. As these costs are typically not included in the ETF’s ongoing charge, investors may find it hard to correctly assess the total cost of owning a synthetic ETF. Swap counterparties can charge a spread which will impact the tracking difference of the fund.