World Tour: where swap-based ETFs could have an advantage

Investment risks

For complete information on risks, refer to the legal documents.

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.

So, you want to invest in ETFs.

Now it’s time to figure out which ETF structure is right for you.

You might come across two options: physical, and synthetic – often called swap-based. Don’t worry. It’s not as complex as it sounds.

Physical ETFs buy the shares in an index. Swap-based ETFs replicate the performance of a given index, without having to own the shares directly.

In certain markets, swap-based ETFs have clear advantages.

Let’s take a tour of some of those markets.

[cut to the USA]

In the US equity market, the main advantage of investing in swap-based ETFs is the ability to generate outperformance relative to the index being tracked. 

The performance of an equity index will be determined by the movement in share prices plus the value of any dividends paid out by those companies. Company dividends can be subject to a tax called withholding tax which reduces the value of dividends received by an ETF. When investing in US companies, the standard rate for this withholding tax is 30%.

A physical ETF may be able to reduce this tax to 15%. However, US tax law allows swap-based ETFs to reduce this tax to zero for certain indices. These indices include one of the world’s most famous benchmarks, the S&P 500 Index.

Because of this tax advantage, swap-based ETFs can outperform physical investments in US shares. Indeed, over the past five years the Invesco S&P 500 UCITS ETF has beaten its benchmark, the S&P 500 Total Return Net Index, by more than 2%. For full performance data please see the end of this video, and, as with all investing, that performance will fluctuate, and it can't be guaranteed.

US shares make up a large proportion of many investor portfolios, so securing even a small performance lift could be helpful to boost overall returns.

This swap-based approach can also apply to a global equity ETF. US companies make up around 70% of the MSCI World index, so reducing the withholding tax to zero can also have a meaningful impact on portfolio returns compared to physical ETFs. 

There are also other parts of the world where swap-based ETFs have an advantage but not due to withholding tax. Let’s go to China next…

China is the world’s second largest equity market. Companies here issue different types of equity and “China A-shares” represent the majority of shares listed on the Chinese stock market. This market was historically only accessible to domestic investors but has gradually opened up to investors outside of China.

In China’s A-Share market, swap-based ETF’s benefit from a unique market dynamic that could boost your investment returns. This is due to limitations on how investors outside of China can access the market and because of this, swap-based China A-Shares ETFs have been able to generate a significant level of outperformance versus the indices that they track. For example, the Invesco S&P China A 300 Swap UCITS ETF has beaten its benchmark, the S&P China A 300 Index, by 1.8% over the past year. For full performance data please see the end of this video, and again, as with all investing, that performance will fluctuate, and it can't be guaranteed.

Third on our world tour are the Emerging Markets, a broad category of countries that are a little harder to access for international investors when compared to the Developed Markets of the US, Europe, and Japan.

Emerging markets indices are good candidates for swap-based ETFs. It can be expensive and operationally difficult for an ETF to invest in all the stocks in an Emerging Markets index, potentially hurting investment performance.

Instead, it can make sense to replicate these indices without holding the shares directly via a swap-based ETF.

Last stop on our trip is closer to home. You might be able to boost your returns with swap-based ETFs on familiar UK and European stock markets like the FTSE 100 Index or the EURO STOXX 50 Index. Once again, taxation can have an impact on the ETF you choose, but not withholding tax this time, instead we are focusing on Stamp Duty and Financial Transaction Taxes.

Let’s look at an example. When a physical ETF buys the constituents of the FTSE 100 Index, the ETF will need to pay stamp duty at 0.5% for most of the stocks that it buys. This cost is passed on to the investor either as a drag on investment performance or in a higher price per share when buying the ETF.

Swap-based ETFs have the ability to sidestep this stamp duty tax by not holding these stocks directly. A similar situation can be found when an ETF replicates a European index, with financial transaction taxes liable on purchases of shares in markets such as Italy and France. 

To summarise, the potential performance boost from a swap-based ETF won’t make you rich overnight, however adding together lots of small enhancements might lead to something much bigger than you expect. 

Explore the risks and the benefits, and see if swap-based ETFs could give your portfolio a boost and improve your long-term performance. 

Important information

Data as at 31 July 2024, unless otherwise stated.

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.

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UCITS ETF’s units / shares purchased on the secondary market cannot usually be sold directly back to UCITS ETF. Investors must buy and sell units / shares on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current net asset value when buying units / shares and may receive less than the current net asset value when selling them.

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