Your Financial Engineer is back. Can you trust him? (How to choose a Safe Synthetic ETF)

How to choose a SAFE Synthetic ETF

Your Financial Engineer is back, but can you trust him?

Over the past decade, and following complex financial engineering that partially caused the Global Financial Crisis in 2008, synthetic ETFs were treated with caution. 

ETF providers, especially for European Funds tracking US Equities, have recently embraced synthetic replication and there are reasons, including incremental returns, why as a more hands-on Investor you may consider them in your portfolio.

Here is all you need to know about risks involved and how to choose the Best S&P 500 ETF.

ARE SYNTHETIC ETFs suitable for me?

WHEN YOU SHOULDn'T invest through Synthetic ETFs

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 – just follow the money.

The best portfolio is a portfolio you understand.

Unless you consider getting marginal benefit from your US exposure, there is no reason to make your portfolio complicated and potentially more risky. 

For Global ETFs that track both Developed and Emerging Markets there is no evidence of outperformance of Synthetic vs. Physical replication.

Interestingly, even for Developed Countries’ ETFs tracking e.g. MSCI World Index, there is currently no return benefit in investing through a Synthetic ETF.

WHEN YOU MAY invest through Synthetic ETFS

If you have a Banker-type portfolio, a Synthetic ETF with US-heavy allocation may bring incremental returns. 

You probably already know what is a Swap, but may be wondering how these are implemented in an ETF.

Unlike the World ETF, a US-centric ETF (e.g. 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 need to be aware of.  

CHASING Higher returns

Have a cake and eat it too

Physical vs. Synthetic replication

Let’s have a look at two ETFs that have a long track record.

The Invesco S&P 500 UCITS ETF (Synthetic replication) and iShares CORE S&P 500 UCITS ETF (Physical replication) have both over 10 years of data. 

If we look at the distribution of excess returns (over S&P 500 Benchmark), some months with significant Tracking Error exist for both ETFs. 

They are in general symetrically distributed and corrected the following month (as they often relate to reporting).  

What else do we see on the chart?

As a general rule, S&P 500 Synthetic ETFs tend to outperform their Physical equivalents more frequently. What’s more, the Synthetic ETFs also tend to have a lower Tracking Error.

Why do Synthetic ETFs outperform?

If you hold a physical US equity ETF domiciled outside the US, the
dividends paid to the fund are generally subject to US Dividend Withholding Tax. 

The tax on dividends can be as high as 30% in the US, if no favorable 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 a withholding tax. 


While for derivatives or securities that reference dividends paid by US stocks, the US Internal Revenue Code (rule 871m) applies the tax to dividend equivalent amounts received by non-US persons, a derivative with respect to a “qualified index” such as the S&P 500 is, as it currently stands, out of scope of the 871(m) rule.

By how much do Synthetic ETFs outperform?

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 at around 30 basis points per year (or 0.3%).

Note, that as of May 2021, the dividend yield is a bit lower, at 1.3%.

What about the Swap fee?

Another cost that needs to be accounted for is the Swap fee charged by the Bank. 

In general, these fees tend to be very competitive. 

Most ETF Providers do not disclose them. But having an insight into one gives an idea of the costs involved.

For instance, one of the Top 3 S&P 500 UCITS ETFs has currently a swap fee of 0%.

Best Synthetic S&P 500 UCITS ETFs

While the iShares CORE S&P 500 Physical ETF tracked the S&P NET Benchmark very closely the synthetic ETFs achieved a noticable outperformance.

The below table shows that on average Synthetic ETFs outperformed a Physical ETF by around 30 basis points (0.3%)

Annualized Returns over 3 and 5-year periods of Best S&P 500 Synthetic ETFs

From a performance perspective, all synthetic S&P 500 UCITS ETFs had a similar performance over 3-year and 5-year periods. 

Two ETFs are leaders in this space and have assets under management of over EUR 6bn:

  • Invesco S&P 500 UCITS ETF 
  • Xtrackers S&P 500 Swap UCITS ETF 

While the Xtrackers ETF has a slightly superior performance over 5 years, it tends to have a higher tracking error. 

However, with the merger of Lyxor and Amundi, the combined assets of these two ETFs will be equivalent to the two leaders. There is no clarity how these will be merged, though.

BlackRock’s iShares is much smaller, but this is due to the fact that BlackRock was generally opposed to the idea of synthetic ETFs until very recently. Its fund has been quite successful since launch, though.

TER has played a minor role overall, if any.

How should you choose from this list?

For similar performance, a tie-breaker may be more comfort around certain operational risks.

Read on. 

Best Synthetic MSCI World UCITS ETFs

Given the weight of US Markets within MSCI World, you may have expected that Synthetic ETFs also gain a certain competitive advantage over Physical ETFs. 

Based on current performance most ETFs using Physical replication still have similar or even superior returns to Synthetic over a 3 and 5 year horizon.

Annualized Returns over 3 and 5-year periods of Best MSCI World Synthetic ETFs


This could come from the fact, that European Markets have an impact too and Physical ETFs achieve additional fees for Securities Lending. 

Other benefits include local taxes. ETFs domiciled in e.g. France won’t pay French dividend withholding tax.

Managers of Physical ETFs may also add value through superior management of Corporate Actions.

This space should be watched carefully though as the dynamic may change depending on how tax regimes evolve and additional revenues. 

In a nutshell, currently there is little benefit in using Synthetics to get exposure to the Developed Markets.


Risk considerations

Are synthetic ETFs safe?

In general, ETFs using synthetic replication are safe. 

Despite additional counterparty risks, an unfunded swap structure with frequent resets mitigates most of risks. 

For ETFs with a funded swap structure, the Fund should have a transfer of title in place and be sufficiently over-collaterlizated.

Securities lending vs. synthetic etfs

A popular argument for Synthetic ETFs is that Physical ETFs engage in Securities Lending and thus also have counterparty risk. 

While this is true, with securities lending there are (i) mitigating measures and (ii) you have a contractual revenue that as an investor you will get from this activity.

If you choose a Synthetic ETF you must be assured there is an outperformance or clear benefit linked to that e.g.:

  • Withholding tax
  • Access to a market in a way you are not able to through Physical ETFs
Otherwise investing through a Synthetic makes little sense.

All synthetic etfs are not created equal

Questions that you need to answer to better understand risk factors related to ETF Structure may include:

  • Step 1 – How does my Synthetic ETF work?
  • Step 2 – Which Bank(s) is the Swap Counterparty? 
  • Step 3 – Which Equities are held in the substitute basket?
  • Step 4 – How frequently are Swaps reset?
  • Step 5 – What happens if the Bank defaults?
Risk characteristics of Best S&P 500 Synthetic ETFs

STEp 1 - How does A synthetic etf work?

While a Physical ETF holds the underlying securities, a Synthetic ETF gets exposure to the returns through a SWAP, most often with a Bank counterparty.

This Swap can be:

  • CASE 1 – Unfunded
  • CASE 2 – Funded with ownership of the collateral
  • CASE 3 – Funded with pledge to the collateral
CASE 1 - Synthetic ETF with Unfunded Swap
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.

  • ETF Investors’ cash is used to buy securities in a ‘substitute equity basket‘ – this often comprise Equities of major indices (e.g. Eurostoxx 50 in the example above) but avoids certain ETF Benchmark Equities (for tax efficiency purposes)
  • 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
  • In case of default of the Bank on its obligations the ETF can use the substitute basket 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
CASE 2 - Synthetic ETF with 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, almost entirely.
  • 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 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.
  • In case of default of the Bank on its obligations the ETF can use these transferred securities to either (i) re-establish the swap with another Bank (ii) sell the basket, which can be very different to ETF Benchmark in this case e.g. collateralised by Bonds, and buy the index securities to physically track it or (iii) liquidate the ETF and return the cash to investors
CASE 3 - Synthetic ETF with Funded Swap and Pledge

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 scenarios here is if the bankruptcy administrator decides to freeze the assets.

STEp 2 - Which bank is the counterparty?

Part of BlackRock’s initial reticence towards Synthetic ETFs came from the fact that all of 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 reputation of the Banks matters too. 

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

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 from the Bank with regular updates of holdings is essential.

A Basket that is highly correlated with the ETF Benchmark can help reducing tracking error if the Bank defaults.


STEp 4 - how frequently are swaps reset?

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.

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?

This is a key one. Two possible cases can arrise. A single counterparty goes bankrupt or there is a Banking Crisis.

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.

Good Luck & keep’em* rolling!

(* Wheels & Dividends)

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About Raph Antoine 83 Articles
Raph Antoine is a Portfolio Manager and Institutional Advisor that witnessed first-hand the 2008 Global Financial Crisis and the 2011 European Debt Crisis working for some of the most prestigious names in the financial industry. Raph has experience across multiple asset classes including Fixed Income and Equity products as well as Special Situations and Restructurings in multiple jurisdictions. Raph holds an MSc in Financial Engineering and is a CFA (Chartered Financial Analyst) Charterholder. He usually rides one of his two bikes. Rarely, a Canyon Ultimate CF SLX 8.0 (that is currently in family's attic) and most of the time a Gravel Pinnacle Arkose (his favourite) that he used to Cycle the World.
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7 months ago

Really good stuff 🙂 Thank you!

Given that historical S&P 500 dividend yield (DY) mean is 4% synthetic ETF can have even higher upside if DY will revert to the mean?

What you mean by „superior management of Corporate Actions”? Possibility to influence management of companies? In this case all shareholders benefit also synthetic despite that they are not shareholders per se.

Ps. Now is time for factor (incl. momentum) investing via ETFs;)

7 months ago

Do the synthetic etfs also split into acc and dist?

7 months ago

Best resource on Synthetics and clear explanation. Thank you.

3 months ago

Good post. Securities lending weren’t always like that, some ETFs providers used to accept junk in their collateral, lend a LOT of their portfolio and keep the majority of the benefits for themselves. Ishares criticized synthetic etfs mainly for commercial reasons, funny to see them doing a u-turn now. The good thing is that both securities lending and synthetic ETFs are more regulated now and safer than before. The drawback is that I’m afraid synthetic ETFs will die, even though they makes sense in some circumstances. You name some of those(in my country the tax advantage is huge) but you… Read more »