Introduction

While the debate between physical and synthetic ETFs has calmed in recent years, investors need to understand the key differences between the two replication methods.

Put simply, physical ETFs own the underlying assets they are designed to track while synthetic ETFs do not and instead, enter into a swap agreement with a counterparty that is obliged to provide the return of the index minus fees.

This means synthetic ETFs can track their underlying index more accurately than physical ETFs which are beholden to swings in tracking error, however, there is counterparty risk involved.

However, some physical ETFs engage in securities lending – a process when the issuer loans the underlying assets to a counterparty – which can deliver additional returns but also introduces counterparty risk.

Furthermore, when an underlying index is made up of thousands of securities, ETF issuers may employ a sampling methodology on physical ETFs which can reduce overall trading costs but can increase tracking error, depending on the skill of the portfolio manager.

Shift in sentiment

In the build-up to the Global Financial Crisis (GFC), physical and synthetic ETFs accounted for roughly 50% of the European market, however, in a post-2008 world, synthetic ETFs became hugely unpopular with investors due to counterparty risk involved.

In many cases, the parent bank of the ETF issuer was the exclusive swap provider – Deutsche Bank for DWS or Société Générale for Lyxor – which led to conflicts of interest as the issuer had no incentive to find a good deal with a swap counterparty.

Furthermore, the International Monetary Fund (IMF) and the Financial Stability Board issued warnings about the dangers of synthetic ETFs in 2011 which led to investors piling into physically-replicated ETFs.

According to data from Morningstar, over 80% of equity ETF assets in Europe are now in physical ETFs with this figure jumping to 95% for fixed income products.

Evolution and Renewed Interest

However, steps have been taken by ETF issuers to improve the synthetic ETF structure including the use of multiple swap counterparties and increased transparency on the collateral baskets.

In response to these changes, investors in Europe have become far more agnostic to the two replication methods, depending on the exposure they are looking to access.

When buying US strategies, for example, synthetic ETFs hold an advantage as they do not pay withholding tax on dividends as the substitute basket of the ETFs are restricted to non-dividend paying stocks while physical ETFs domiciled in Luxembourg pay 30% withholding tax on US equity dividends and Irish-domiciled ETFs pay 15%.

A shifting debate

This advantage even led BlackRock to launch a synthetic S&P 500 ETF, the iShares S&P 500 Swap UCITS ETF (I500), in September 2020.

To see such a staunch advocate of physical ETFs in BlackRock bring a synthetic ETF to market shows how the debate has shifted in recent years and highlights how it very much depends on the exposure an investor is looking for.