Inhalt

Is there an advantage to synthetic replication?

The argument around which method, physical or synthetic replication, is ideal for tracking an index has mostly concluded with both methods acknowledged for their potential advantages. Our stance has always been to evaluate each on a case-by-case basis, or more precisely, to scrutinize each index to determine if there's an opportunity to leverage.

 

Nima Pouyan 
Head of Institutional & ETF Distribution Switzerland, Invesco    

 

Here, we identify five examples where we believe synthetic replication could provide a clear structural benefit.

  • US equity indices
  • UK equity indices
  • European equity indices
  • Global equity indices
  • China A-shares indices

 

The two replication methods

Physical replication is the most straightforward method, involving purchasing all constituents in the index proportionally and rebalancing those holdings whenever the index does. Other than the costs involved, including those related to trading and rebalancing of the securities, the ETF’s performance may differ from that of the index depending on, for example, how the ETF treats dividends and any revenue arising from securities lending. For indices with some less-liquid securities, an ETF´s performance may hold solely a representative portion of the index. Sampling techniques typically yield lower costs than full physical replication but come at the expense of higher tracking error compared to the index.

In contrast, an ETF can achieve more consistent index performance by employing swaps. Synthetic replication utilises derivative contracts as agreements between the ETF and a counterparty or several counterparties to exchange cashflows (swapping). Typically, the ETF would receive the exact index performance, subtracting the fee charged for the swap contract.

 

Synthetic replication for US equity indices

Among the largest and longest-running synthetic ETFs are those that track major US equity benchmarks, including the S&P 500 and MSCI USA indices. While a physically replicated ETF that is based in a European jurisdiction with a tax treaty with the US is subject to reduced withholding taxes on the dividends it receives, a synthetic ETF can receive the gross return of the index. This means that it is not subject to dividend withholding tax. As a consequence, an created ETF located in Ireland could attain an extra 15% dividend value as opposed to a physically mirrored ETF likewise placed in Ireland. In a simple calculation a 2% Dividend Yield would mean that the ETF that replicates the gross index outperforms the net index by 60 basis points (30% US Witholding Tax x 2% Dividend Yield).

This advantageous structure is based on the US legislative framework from the yeat 2017. Section 871(m) of the US HIRE Act specifically exempts swaps written on indices with plentiful and fluid derivatives markets from having to pay dividend withholding taxes. This allows a US bank to write a swap that provides the gross return of the index to an ETF based outside of the US.

 

Synthetic replication for world equities

An ETF employing synthetic replication to track a worldwide benchmark could potentially profit from various tax treatments. For example, a swaps-based ETF on the MSCI World index would not be responsible for dividend withholding tax on US elements, nor would it have to pay Stamp Duty or financial transaction taxes on its UK, Italian and French constituents. Using swap contracts may also prove to be a more economical approach to monitoring such a sizable index when compared to purchasing and selling every component via a physical replication method.

 

Potential advantage of synthetic for China equity exposure

The China A-Shares market presents an intriguing case where synthetic replication may offer benefits, not due to tax treatments, but rather due to the market's distinctive dynamics. Market-neutral strategies demonstrate strong performance in this market, yet hedge funds often encounter obstacles as securities lending and hedging mechanisms are not readily available. Consequently, they frequently turn to banks to hedge their risks. Banks provide these services (for a considerable fee) and are prepared to pay an ETF to assume market exposure through a swap agreement.

In a typical market, the ETF is required to pay a swap fee to the counterparty, but a typical market dynamics in China may result in a negative fee, indicating that the ETF will receive the swap fee from the counterparty. With a negative swap fee, the ETF could offer better performance than the index return. The swap fee amount and potential outperformance may fluctuate over time. For the China A mid cap we speak of an annua premia that was historically in the range of 8-16% just due to the synthetic structure.

 

What about risk?

Synthetic replication comes with its own set of risks, but these risks can be mitigated through careful consideration. The majority of synthetic ETFs endeavour to minimize this risk by maintaining a portfolio of superior equities.

Moreover ETFs own a basket, which is not utilized as collateral but is expected to generate returns for the ETF and has a low tracking error to the replicated index. For instance the basket holds a substantial portion of US Equities if the replicated index is an US Index. 

Furthermore the use of multiple counterparties: synthetic ETFs may have a maximum of six counterparties, diminishing the potential financial ramifications for the ETF if a single counterparty defaults. Counterparties tend to have credit ratings, and they are monitored regularly while performing stress tests for potential risk scenarios.

 

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. For complete information on risks, refer to the legal documents.

A synthetic ETF’s ability to track a benchmark’s performance is reliant on the counterparties to continuously deliver the performance of the benchmark in line with the swap agreements and would also be affected by any spread between the pricing of the swaps and the pricing of the benchmark. The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose a synthetic ETF to financial loss.

For further information : LINK

 

Important information

This marketing communication is exclusively for use by professional investors in Switzerland. It is not intended for and should not be distributed to the public.

Data as at 31 July 2023 unless otherwise stated.

By accepting this material, you consent to communicate with us in English, unless you inform us otherwise.

This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.

Views and opinions are based on current market conditions and are subject to change.

Issued by Invesco Asset Management (Schweiz) AG, Talacker 34, CH-8001 Zürich, Switzerland. RO3087056

 

 

Biography

Nima Pouyan has been Head of Institutional & ETF Distribution Switzerland at Invesco since 2017. In his role he is responsible for ETF business development in Switzerland and Liechtenstein and works with banks, asset managers, family offices, discretionary managers and institutional investors from the insurance and corporate sectors.

Previously, Nima Pouyan was Vice President of Passive Investment Sales in Switzerland and the Middle East at Deutsche Bank. Prior to that, he held senior positions at DWS and Deutsche Bank Wealth Management.