Why investors are flocking to synthetic S&P 500 ETFs

Oct 28th, 2019 | By | Category: ETF and Index News

By Chris Mellor, Head of EMEA ETF Equity Product Management, Invesco.

Chris Mellor, Head of EMEA ETF Equity Product Management, Invesco

Chris Mellor, Head of EMEA ETF Equity Product Management, Invesco.

The $3.5 billion of net flows year-to-date into Europe-domiciled S&P 500 ETFs shows the continued demand for the asset class, but a closer look at how investors are choosing to gain exposure to this important benchmark is perhaps more telling.

$4 billion has been into ETFs that replicate the index synthetically, while physically replicated ETFs have seen net outflows. We are not suggesting the presence of an overwhelming preference for one replication model over another, but this merely highlights how the chosen method can sometimes be significant for investors.

As a quick refresher, full physical replication involves holding all the stocks in the index and rebalancing whenever the index does, while synthetic replication invests in a broad basket of equities and uses swaps to deliver efficient replication of the index.

You are likely to find pros and cons with both methods and, assuming the physical version engages in securities lending, they are both exposed to counterparty risk. There are various measures that an ETF provider can put in place to mitigate this risk, including frequent swap resets and only dealing with creditworthy counterparties.

Sophisticated investors now appear to understand the various risks with each replication method and are using other determining factors to select which one is most suitable for their needs.

Total cost of ownership is a good starting point, with S&P 500 ETFs available in Europe for as little as 0.05% p.a. (and up to 0.20% p.a.). How well the ETF tracks the index is another consideration, but this is where the comparison takes an interesting twist when we are talking about US equity indices.

Synthetic advantage is the real thing

ETFs that synthetically replicate major US equity benchmarks have clear structural advantages over physical ETF models, which has delivered outperformance and helps explain the big difference in demand.

Foreign investors in US stocks are generally subject to a withholding tax on dividends of up to 30%, although many can reduce this to 15% through the application of tax treaties. However, under US tax law, namely the HIRE Act 871m, swaps written on indices with deep and liquid futures markets, e.g. the S&P 500, are not required to pay withholding taxes on dividends.

This means that while a European-domiciled physically replicating S&P 500 ETF will generally be able to achieve a maximum of 85% of the dividend yield, a synthetic fund can theoretically achieve up to 100% of the full gross dividend amount. With the S&P 500 yielding around 1.9% (2% on average over the past decade), this exemption means synthetic funds can potentially achieve up to 30 basis points of additional performance each year.

Performance of Invesco S&P 500 UCITS ETF and the largest physical ETFs

Source: Invesco.

Look for advantages elsewhere

While the advantage is easy to see in replicating the S&P 500 or MSCI USA index, it’s less straightforward in non-US markets. For instance, in Europe, a physical fund may have to pay stamp duty or financial transaction tax (FTT) when buying shares in certain countries but may be able to offset this with higher dividends achieved through securities lending.

For synthetic funds, the index swap market will generally reflect the same enhanced economics available in the stock lending market, putting the two methods on a level playing field from that aspect. However, the synthetic structure may gain the upper hand by not having to pay stamp duty or FTT.


Investor views and preferences on the relative merits of physical and synthetic ETFs vary and many are deeply entrenched. However, as the industry matures, investors are increasingly adopting the more pragmatic stance that was previously only common among sophisticated investors.

Other things being equal an investor may prefer the simplicity of a physical fund or the very tight tracking of a synthetic approach. However, where one approach has a structural advantage over the other, investors are increasingly willing to prioritize performance and remain flexible on structure.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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