Can You Trust The Banker? How To Choose The Best S&P 500 ETF.

The Definitive Guide to Equity Index Investing - PART 6

This article is Part 6 of our definitive guide to Equity Index Investing.

Back in 2009, I managed client portfolios of CDO and CDO-Squared – some of the most complex and toxic financial instruments ever assembled by Wall Street Banks. After working out structured finance portfolios, synthetics raised my eyebrows. Not very Golden-retriever friendly, to say the least.

Over the past years, though, the products got safer. Why do investors choose them? French Investors get around restrictions to invest in companies outside Europe within the PEA tax wrapper. Other Europeans use them to avoid being taxed on US Dividends. 

But how competitive are they today compared to the cheapest physical ETFs like the $5.5bn SPDR S&P 500 UCITS ETF that will see its TER cut from 0.09% to 0.03% in November 2023?

KEY TAKEAWAYS

  • Not everyone will benefit from savings – If you want a hassle-free, one-ETF portfolio, a synthetic ETF may not be the best choice. Only granular portfolios with dedicated S&P 500 ETFs may benefit.
  • Tax savings may boost S&P 500 ETF performance.  That’s because U.S. Stocks’ dividends are taxed between 0% and 30%. Physical ETFs domiciled in Luxembourg pay 30%, Irish ETFs have a preferential tax treatment of 15%, but Synthetic ETFs do not pay any tax.
  • Synthetic S&P 500 ETFs outperformed 0.07% TER Physical ETFs by 0.2% to 0.3% annually. The fee of the SPDR S&P 500 UCITS ETF that as of Q4’23 is 0.03% is still insufficient to outperform synthetics.
  • There could also be savings with MSCI World ETFs. Since we first ran this analysis two years ago, Synthetic MSCI World ETFs also caught up. They are a preferred choice for French Investors in PEA tax wrappers.
  • Synthetic ETFs are not without risks. Tax laws may change. But exposure to Banks can be mitigated. Based on my experience, an unfunded swap structure, solid bank counterparties, a liquid basket that resets frequently can mitigate risks.
Here is the full analysis

Should You BuY a Synthetic ETF?

WHEN YOU SHOULDn'T invest through Synthetic ETFs

The best portfolio is a portfolio you understand.

Synthetic ETFs may not be suitable for investors that are just starting out. Simple investments using physical replication are great, cost-efficient and hassle-free. The best portfolio is a portfolio you understand. Unless you consider a dedicated allocation to US or Developed Markets, there is no reason to complicate your portfolio and make it operationally riskier.  For Global ETFs that track both Developed and Emerging Markets, there is no evidence of outperformance of Synthetic vs. Physical replication.

WHEN YOU MAY BENEFIT FROM Synthetic ETFS

You want a dedicated S&P 500 exposure

Synthetic ETF may bring incremental returns, if you have a portfolio with dedicated allocation to US Stocks. You probably already know what a Swap is, but may be wondering how these are implemented in an ETF. Unlike a Global ETF, a US-centric ETF, like the S&P 500, doesn’t have to be domiciled in Ireland or the US, to be tax efficient. But there are also red flags to look out for and risks you must be aware of.

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What are the Benefits?

S&P 500 ETFs - iShares (TER: 0.07%) vs Invesco (TER: 0.05%)

TER doesn't tell you the whole story

To understand the difference in performance, let’s have a look at two ETFs that are references in their asset class with a long (10+ years) track record:

  • The Invesco S&P 500 UCITS ETF with Synthetic replication (0.05% TER)
  • The iShares CORE S&P 500 UCITS ETF with Physical replication (0.07% TER)
In theory, Invesco should marginally outperform, but if you look closer, the outperformance is more significant.

No Matter How you look at it, SyntheticS Outperform

Two benefits

Higher performance & More reliable tracking

If we look at the distribution of ETFs’ excess returns vs. S&P 500, we can see:

  • Better Tracking Difference – The Invesco S&P 500 Synthetic ETF tends to outperform its Physical rival more frequently.
  • Better Tracking Error – What’s more, Synthetic ETFs also tend to have a lower Tracking Error. That means the Invesco ETF tracks the Index better.

Why do Synthetic ETFs outperform?

You don't pay taxes on US Dividends

If you hold a UCITS ETF, with physical replication, the dividends will be subject to US Dividend Withholding Tax.  Withholding tax can be as high as 30%, if no favourable tax treatment is applied.  Withholding tax are important to pay attention to when selecting an ETF. In general, however, Physical ETFs pay a reduced rate of 15%. A Synthetic ETF doesn’t pay any withholding tax. Why?  In theory, the US Internal Revenue Code (rule 871m) applies a tax on dividend equivalent amounts received by non-US persons. But, a synthetic ETF on a “qualified index” like the S&P 500 is structured as a swap. Such derivatives on qualified indices are, as it currently stands, out of scope of the 871(m) rule.

By How much will the ETFs outperform?

Every year, the outperformance may be around 0.2-0.3%

As a general rule, with a dividend yield of around 2% on the S&P 500 over the past few years, the tax savings are 15% x 2%, which comes out to around 30 basis points per year (or 0.3%). Note that as of October 2023, the dividend yield is a bit lower, at 1.7%.

Are there any other fees involved?

Swap Fees are very low, probably around 0%

Another cost that needs to be accounted for is the Swap fee charged by the manager. In general, these fees tend to be very low for the popular indices. Most ETF Providers do not disclose them. But having an insight into one gives an idea of the costs involved. A leading S&P 500 UCITS ETFs currently has a swap fee of 0.035%. In any case, its impact is included in the Tracking Difference.

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How To Choose the Best S&P 500 UCITS ETF?

Physical ETFs,no matter how cheap are lagging

An annual excess return of about 0.26% over the past 3 years

As you can see below, the Invesco S&P 500 UCITS ETF outperformed the Net Index by 0.48% annually. The iShares managed to outperform by 0.22%. So, the synthetic ETF generated an annual excess return of 0.26% vs Physical ETFs.

S&P 500 ETF Selection

RankS&P500_UCITS_FUNDS3Y TDTERAcc.Dist.ReplicationSizeInceptionDomicileBenchmarkAcc ISINDist ISINRank Category
1Invesco S&P 500 UCITS ETF0.48%0.05%
Synthetic12.705/2010IrelandS&P 500 Net Total Return IndexIE00B3YCGJ38IE00BYML9W36Synthetic
2Xtrackers S&P 500 Swap UCITS ETF0.47%0.15%
Synthetic6.003/2010LuxembourgS&P 500 Net Total Return IndexLU0490618542LU2009147757Synthetic
2Lyxor S&P 500 UCITS ETF0.45%0.09%
Synthetic2.003/2010LuxembourgS&P 500 Net Total Return IndexLU1135865084LU0496786657Synthetic
2Amundi S&P 500 UCITS ETF0.48%0.15%
Synthetic2.803/2018LuxembourgS&P 500 Net Total Return IndexLU1681049018LU2391437253Synthetic
3BNP Paribas Easy S&P 500 UCITS ETF0.44%0.15%
Synthetic1.906/2008FranceS&P 500 Net Total Return IndexFR0011550177FR0011550680Synthetic
1iShares CORE S&P 500 UCITS ETF0.22%0.07%
Physical61.503/2002IrelandS&P 500 Net Total Return IndexIE00B5BMR087IE0031442068Physical
1Vanguard S&P 500 UCITS ETF0.23%0.07%
Physical31.805/2012IrelandS&P 500 Net Total Return IndexIE00BFMXXD54IE00B3XXRP09Physical
Source: Bloomberg, Bankeronwheels.com. Data as of February 2023. Definitions: 3Y TD - Annualised 3-year Tracking Difference. It is the ETF outperformance vs. a Total Return Net Index. Net Index represents the worst case tax treatment e.g. 30% for US Dividends. TER - Total Expense Ratio. Acc - Accumulating Share Class. Dist. - Distributing Share Class. Acc/Dist Cumulative size in € billion .

Best S&P 500 ETF

Invesco S&P 500 UCITS ETF

Synthetic ETFs dominate this market, and Invesco S&P 500 UCITS ETF is the largest (over twice the size of its closest competitor) and most liquid synthetic fund. 

Best Alternatives

Synthetic ETFs from Xtrackers and Amundi

The difference in performance between runners-up is marginal. Also, with the merger of Lyxor and Amundi, the combined assets of these two ETFs is equivalent to Xtrackers

iShares synthetic ETF, not listed in the above table, is much smaller, because BlackRock was opposed to synthetics until recently. Its fund has been quite successful since launch, though. How should you choose from the list? For similar performance, a tie-breaker may be more comfort around certain operational risks.

iShares Core S&P 500 UCITS ETF remains the largest fund at c. 5x Invesco, but the physical replication implies lower performance.

Will SPDR S&P 500 UCITS ETF (TER: 0.03%) outperform?

No, it is unlikely to outperform due to taxes

Effective 1 November, the $5.5bn SPDR S&P 500 UCITS ETF (SPY5) will see its total expense ratio (TER) cut from 0.09% to 0.03%, the cheapest S&P 500 ETF on the European market. 

However, this is only 0.04% better than the Physical ETF from iShares ETF. It’s not enough to outperform Synthetic rivals, given that it is domiciled in Ireland. 

How To choose the Best MSCI World ETF?

Are synthetics worth consideration outside the S&P 500?

Taxes play a role as US Equities represent 70% of MSCI World

When we first performed the analysis in Q1’21, Physical ETFs still had a clear edge. The annualised 3-year Tracking Difference outperformance of HSBC MSCI World UCITS ETF vs Invesco MSCI World UCITS ETF was 15 bps, or 0.15%. Today, the difference is only 0.07%. Given the 70% weight of US Markets within MSCI World, Synthetic ETFs are catching up. 

Can they Outpeform?

Today, it's not clear-cut, as European Markets Matter Too

How do Physical ETF still manage to compete? European Markets have an impact too, and Physical ETFs achieve additional fees from Securities Lending. Managers of Physical ETFs may also add value through superior management of Corporate Actions. This space should be watched carefully, as the dynamic depends on evolution of tax regimes and additional revenues.

Developed Markets ETF Selection

RankDeveloped_Markets ETF3Y TDTERAcc.Dist.ReplicationSizeInceptionDomicileBenchmarkAcc ISINDist ISINRank Category
1iShares Core MSCI World UCITS ETF0.08%0.20%
Physical43.709/2009IrelandMSCI World Total Return Net IndexIE00B4L5Y983
Physical
1HSBC MSCI World UCITS ETF0.22%0.15%
Physical4.512/2010IrelandMSCI World Total Return Net Index
IE00B4X9L533Physical
2Vanguard FTSE Developed World UCITS ETF0.10%0.12%
Physical2.909/2014IrelandFTSE Developed Net Total Return IndexIE00BK5BQV03IE00BKX55T58Physical
3SPDR MSCI World UCITS ETF0.14%0.12%
Physical1.902/2019IrelandMSCI World Total Return Net IndexIE00BFY0GT14
Physical
4Xtrackers MSCI World UCITS ETF0.07% / 0.05%*0.19% / 0.12%*
Physical9.207/2014IrelandMSCI World Total Return Net IndexIE00BJ0KDQ92IE00BK1PV551Physical
1Invesco MSCI World UCITS ETF0.15%0.19%
Synthetic3.004/2009IrelandMSCI World Total Return Net IndexIE00B60SX394
Synthetic
1Lyxor MSCI World UCITS ETF (Luxembourg)0.14%0.20%
Synthetic3.311/2008LuxembourgMSCI World Total Return Net IndexLU0392494562
Synthetic
2Lyxor MSCI World UCITS ETF (France)0.06%0.30%
Synthetic0.205/2014FranceMSCI World Total Return Net IndexFR0011869353FR0014003IY1Synthetic
* Xtrackers MSCI World UCITS ETF Distributing and Accumulating Share Classes have different costs. Source: Bloomberg, Bankeronwheels.com. Data as of February 2023. Definitions: 3Y TD - Annualised 3-year Tracking Difference. It is the ETF outperformance vs. a Total Return Net Index. Net Index represents the worst case tax treatment e.g. 30% for US Dividends. TER - Total Expense Ratio. Acc - Accumulating Share Class. Dist. - Distributing Share Class.  Acc/Dist Cumulative size in € billion .

Best Developed Markets ETFs

iShares Core MSCI World UCITS ETF & HSBC MSCI World UCITS ETF

Depending on the dividend distribution policy, current leaders are:

  • iShares Core MSCI World UCITS ETF (Accumulating) – is investor’s favourite, despite its marginal underperformance due to (i) being managed by BlackRock (ii) the Fund being a reference (x4 larger than its closest competitor) and having (iii) the highest Liquidity (5-10x more flows).
  • HSBC MSCI World UCITS ETF (Distributing) – is the best performing fund over the past 3 years and one of the cheapest amongst the largest ETFs. However, there are good alternatives. 

Best Alternatives

Synthetics from Invesco and Amundi

  • For Accumulating ETFs – Both Lyxor and Invesco Accumulating ETFs are worth considering, as synthetic ETFs are rapidly gaining a performance edge. Amundi ETFs are much smaller and with a worse track record. They may be merged with Lyxor at some point.
  • For distributing ETFsXtrackers offers a solid alternative and may challenge HSBC in the future, given a lower TER. Synthetic options exist for distributing funds, but are domiciled in France, and designed for local investors through PEA tax wrappers. 

Vanguard lags the leaders, but offers a low TER and the advantage of a slightly broader coverage in small caps. 

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Risks With synthetic ETFs

Can synthetic ETFs lose their edge?

U.S. Tax Code May Change

Tax laws are subject to changes, in which case Synthetic ETFs may lose their edge.

Are synthetic ETFs safe?

They are safer than in the past, but the devil is in the details.

In general, ETFs using synthetic replication are safe. Despite facing a Bank counterparty, an unfunded swap structure with frequent resets mitigates most of the risks. For ETFs with a funded swap structure, the Fund should have a transfer of title in place and be sufficiently over-collaterlisated. Let’s look at them one by one.

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How To Choose A Safe Synthetic ETF is 5 Steps

All synthetic etfs are not created equal

If you don't understand the steps below, maybe it's wise to consider a physical ETF

Questions that you need to answer include:

  • Step 1 – How does my Synthetic ETF work?
  • Step 2 – Which Bank(s) are you exposed to? 
  • Step 3 – Which Equities are held in the substitute basket?
  • Step 4 – How frequently are Swaps reset?
  • Step 5 – What happens if the Bank(s) defaults?

RiskS For Key Providers

STEp 1 - Which Swap Structure is safest?

Unfunded swaps are usually the safest

While a Physical ETF holds the underlying securities, a Synthetic ETF gets the returns through a SWAP, from a Bank counterparty. This Swap can be:

  • CASE 1 – Unfunded
  • CASE 2 – Funded with ownership of collateral
  • CASE 3 – Funded with pledge to collateral

CASE 1 - Unfunded Swap (SAFEST)

animated example of synthetic replication etf and swap provider

The safest way of investing is through an Unfunded Swap. Almost all UCITS ETFs use this structure:

  • Investors’ cash is used to buy securities in a ‘substitute equity basket‘ – this often comprise Major Indices (e.g. Eurostoxx 50)  but avoids certain US-dividend paying securities.
  • The return on the substitute basket is swapped with a Bank for the return on the ETF benchmark that the ETF tracks (S&P 500).
  • The ETF Provider has full control over assets. The substitute basket is owned by the ETF provider and as such there is very low credit risk, should the Bank default.

CASE 2 - Funded Swap and Ownership

The second best way of investing is through a Funded Swap and ownership of the collateral. A few UCITS ETFs use this structure, e.g. UBS:

  • Investorscash is paid to the Bank, which has a contractual obligation to pay the ETF the index return. There is no return swap payment from the ETF to the Bank.
  • You can think of it as offloading the responsibility of the ETF management to the Bank.
  • In that sense, I tend to think of it more as a Structured Note backed by collateral, rather than a typical Swap.
  • Collateral is pledged to the ETF’s account held with an independent custodian and the ETF legally owns it.
  • It will be operationally more time-consuming, than an unfunded structure, to get access to it when the Bank defaults. The collateral needs to be transferred first. The fund would need to instruct the collateral agent to transfer the assets from the segregated account to the fund’s custody account.
  • Given that the collateral comprises other, often safer securities like Government Bonds, there can be a substantial difference in daily performance compared to ETF Benchmark. To mitigate this risk, the ETF is often over-collateralised, up to 120% of NAV.

CASE 3 - Funded Swap and Pledge (AVOID)

Such Funds may exist but should be a red flag. They work in the same way as the above, but the collateral is only pledged to the ETF.  The ETF is not the beneficial owner of the assets. In a default scenario, the fund would not have direct access to the assets, but would first need to have the pledge enforced.  The worst case scenario here is the bankruptcy administrator freezing the assets.

STEp 2 - Which bank is the counterparty?

Check Bank credit ratings.

Part of BlackRock’s initial reticence towards Synthetic ETFs came from the fact that all the European Synthetic ETF providers were affiliated with their parent Banks. This may create some conflict of interest.

When choosing an ETF, make sure to verify that the provider discloses the Bank counterparties.  Some ETF providers are more transparent about certain risks than others, which is a good sign.

In general, the more Banks, the merrier, since it provides counterparty risk diversification. But the credit ratings matter most.

STEp 3 - Which securities are held in the substitute basket?

Liquid, Correlated to Index asset types are better

This substitute basket is key in case of swap counterparty default. The quality of this Basket may determine the potential opportunity cost and tracking error in case things go wrong.  

A transparent, liquid collateral basket, independent of the Bank, with regular updates of holdings is essential. A Basket that is highly correlated with the ETF Benchmark can help to reduce tracking error if the Bank defaults.

STEp 4 - how frequently are swaps reset?

Daily resets became the standard

By now, I may have convinced you that the Unfunded Swap is the way to invest to minimize counterparty and operational delay risks. However, even in an unfunded swap ETF, there remains counterparty risk because asset values change every day.

Under UCITS regulations, an ETF can only ever put 10% of its value at the risk of a counterparty failure. In practice, this means the ETF’s assets must cover at least 90% of its value. ETF providers have tighter swap resets to limit this risk even further. The higher the frequency, the lower the counterparty risk.

The golden standard is daily resets, to protect close to 100% of the ETF’s value. Other will have implicit rules, but most providers keep it pretty tight nowadays, using e.g. daily MtM and variation margins.

STEp 5 - What happens if the Bank defaults?

Back To Physical / Swap reinstate May avoid Capital Gains Taxes

Two possible cases can arise. A single counterparty goes bankrupt or there is a Banking CrisisIn case of defaultthe substitute basket is used to either (i) re-establish the swap with another Bank (ii) sell the basket and buy the index securities to physically track it or (iii) liquidate the ETF and return the cash to investors.

In the latter case, reinstating a swap may be tricky due to mistrust, similar to 2008, towards Banks in general.  Reverting to physical tracking and experience of the asset manager with such management could play a role to limit the damage. Returning Cash is probably the worst case scenario as it may trigger Capital Gains Taxes.

Thank you for reading.
Good Luck and Keep’em* Rolling!

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