By Vanguard Asset Management.

Why replication really matters for US equity ETF exposures

As global financial markets have been hit by the ongoing coronavirus crisis, many globally diversified investors will be carefully monitoring how their allocations to US equities are performing.

A large portion of these investors probably allocate to the iconic S&P 500, one of the best-known benchmarks for US large-cap exposures. In the European market, there are 15 UCITS ETFs tracking the S&P 500 available.

But as they review the performance of S&P 500 ETFs, an equally important consideration for European investors is how an ETF tracks its benchmark. ETFs use two main replication methods: physical and synthetic, and the range of S&P 500 ETFs in Europe offers investors a choice between these replication approaches.

It’s important that investors understand the implications of these two options. How does their performance differ relative to the benchmark? How transparent are they and what does this mean for due diligence? And what are the main risks associated with each, especially in the current market environment?

Physical or synthetic?

Physical ETFs hold all, or a representative sample, of the underlying securities that constitute the index. They are relatively transparent in terms of the exposures an investor is getting. An investor in a physical S&P 500 ETF owns all of the securities represented in the S&P 500 Index, according to their market cap weightings.

Synthetic ETFs, on the other hand, use swaps to track their benchmark, meaning they can track the performance of an index without actually owning any of its constituent securities. Synthetic products tend to have lower tracking error than physical ETFs, especially in markets with reduced liquidity. But this needs to be considered alongside the different risks they carry and their reduced transparency compared with physical structures.

Dividend tax advantage

Synthetic ETFs are also widely used for UCITS ETFs tracking the S&P 500, in part because they offer a tax advantage over their physical peers. Synthetic S&P 500 ETFs are one of the several instruments exempted from withholding taxes under US Internal Revenue Service (IRS) regulations. As such, synthetic ETFs receive 100% of the dividends paid by the shares in the S&P 500.

Physical ETFs domiciled in Ireland, on the other hand, pay an annual withholding tax of 15%. This compares with the S&P 500 Net Total Return Index, which assumes a 30% withholding tax on dividends. As a result, the majority of synthetic and physical ETFs outperform the benchmark.

Last year, for example, a representative sample of synthetic S&P 500 ETFs outperformed the index by 61-68bps, while the sample of physical products saw 30-34bps of relative outperformance. This performance differential was reflected in investor flows, as synthetic S&P 500 ETFs saw larger inflows than their physical counterparts during most of 2019.

What’s driving performance differences?

What was driving the performance of synthetics? As we have already seen, the variations in dividend yield arising from the tax advantage of synthetic ETFs are one factor. But there could be other contributors.

Net cash inflows themselves, for one, can also aid or detract from performance. Because of the way they’re structured, every swap contract that makes up a synthetic ETF has a reset mechanism which might be triggered by certain dates, market levels, or the size or frequency of cash flows. As a result, large cash inflows and outflows might trigger an adjustment of the swap reset, thus affecting performance. The problem is, it can be difficult to tell how much this is driving returns as these swap reset triggers are not typically disclosed to investors in the ETF.

Another driver which has had a potentially strong impact is cross-currency basis. The swaps on which synthetic ETFs are based require the ETF provider to pay the overnight US dollar funding rate in exchange for receiving the performance of the S&P 500 Index. When there’s a shortage of US dollars in the market (as was the case especially in March this year), the swap counterparty (the ETF provider) ‘lending’ US dollars will charge a premium. This cost may get charged back to the ETF which could detract from performance.

But again, it’s not transparent exactly how much. Because the swap agreements between the ETF issuer and the swap provider are not generally disclosed, it’s difficult to determine what swap costs are charged to the ETF.

Synthetic outperformance not constant

What’s more, it’s important to note that the outperformance of synthetic US equity ETFs is by no means constant over time.

Performance gap has narrowed

Net outperformance of S&P 500 ETFs: four synthetic ETFs vs physical ETF 1 (LHS) and 2 (RHS)

Source: Vanguard.

Source: Vanguard.

Source: Bloomberg, as of 31 March 2020. Notes: The charts above compare two physical ETFs with 4 equivalent synthetic ETFs tracking the S&P 500 Index. Differences between physical ETF 1 and physical ETF 2 include AUM, history, historic OCFs, distribution policy and differences in securities lending practices.

As the charts above show, the performance of synthetic S&P 500 ETFs can vary widely, especially over five- and ten-year periods. However, during the first quarter of 2020, the outperformance of synthetic ETFs relative to both the benchmark and to physical ETFs narrowed significantly. And this contraction was even more pronounced in March when the performance of synthetic and physical S&P 500 ETFs was nearly at par.

The flows reflected this shift as investors moved out of synthetic ETFs during the first quarter.

Flows into synthetic S&P 500 ETFs have reversed

Source: Vanguard.

So what happened? Given the inherent opacity of synthetic ETFs, it’s hard to tell exactly what caused this. One possible explanation is the scarcity of US dollars in the market. The cross-currency basis, which we encountered earlier, had become increasingly negative, resulting in higher costs for synthetic ETF issuers and consequently harming their performance. However, since the Federal Reserve has implemented stimulus measures to support financial markets amid the coronavirus crisis, this shortage has been plugged and the cross-currency basis has started to move into positive territory.

What is clear, however, is that investors cannot count on the consistent outperformance of synthetic S&P 500 ETFs over the long term.

Know what you’re buying

Investors in ETFs should be comfortable that they understand the dynamics of a product, as there are important implications in terms of ownership, risk and complexity.

Physical ETFs directly own all—or a subset—of the securities that make up the index.

But investors in synthetic ETFs are exposed to counterparty risk. In the event of a default by a counterparty, investors only have ownership rights to the underlying collateral pools or reference baskets, which may show large deviations in securities, country weights, sector weights and overall liquidity relative to the target index. Investors need to be sure that this aligns with their overarching risk and return profiles.

Conducting due diligence of synthetic ETFs can be complex and difficult to maintain over time and their lack of transparency can make it challenging to attribute performance.

With a physical ETF, it’s clear what investors are actually investing in and relatively straightforward to monitor how performance is being generated.

Ultimately, it’s up to investors to assess the appropriate balance between protection and return for them. Many investors were clearly comfortable with the risk-return trade-off last year, as reflected in the large inflows into synthetic S&P 500 ETFs.

But now we’re in a very different market environment, one with much more volatility and uncertainty. Investors should ask themselves if they remain comfortable with the inherent risks per unit of benefit that synthetic ETFs come with.

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