Any debate over whether physical or swap-based replication is the best way to track an index has been all but laid to rest, with both methods now appreciated for their potential benefits. We have long argued that each should be judged on a case-by-case basis or, to be more precise, each index should be considered individually to see whether there’s an advantage to be exploited. Here, we highlight five instances in which a swap-based replication method offers a distinct structural advantage.
Physical replication is the most straightforward method and involves buying in proportion all constituents in the index 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 deviate from that of the index depending on, for instance, how the ETF handles dividends and any revenue received from securities lending. For indices with some less-liquid securities, an ETF may hold only a representative portion of the index. Using sampling techniques generally has lower costs than full physical replication but at the expense of higher tracking error versus the index.
In contrast, an ETF may be able to deliver the index performance more uniformly by using swaps. This type of replication method, sometimes referred to as “synthetic” replication, involves the use of these derivative contracts, which are agreements between the ETF and a counterparty, or multiple counterparties, for the exchange (swapping) of cashflows. A swap-based ETF would typically receive the precise index performance, minus a fee for the swap contract.
Among the largest and longest-running swap-based ETFs are those tracking major US equity benchmarks such as the S&P 500 and MSCI USA indices. While a physically replicated ETF, domiciled in one of the European jurisdictions that has a tax treaty with the US, is subject to reduced withholding taxes on the dividends it receives, an ETF using swaps can receive the gross return of the index, i.e., with 0% dividend withholding tax. As a result, a swap-based ETF domiciled in Ireland can benefit from an additional 15% of dividend values, compared to a physically replicated ETF also domiciled in Ireland.
Source: Bloomberg, 12 months to end-June 2024, in USD, average of largest swap-based and physical S&P 500 ETFs in Europe. For illustrative purposes only.
The basis for this structural advantage is embedded within US legislation. Section 871(m) of the US HIRE Act explicitly excludes swaps written on indices with deep and liquid futures markets from the requirement to pay dividend withholding taxes. This enables a US bank writing the swap to return the equivalent of the gross return of the index to an ETF domiciled outside the US.
A swap-based replication method also has an advantage in the UK and some European equity markets. An ETF that physically purchases UK-listed securities, for example, is required to pay Stamp Duty and, similarly, an ETF pays Financial Transaction Tax (FTT) when purchasing shares of companies listed in Italy and France. Those additional costs are reflected in the price of creating shares in the ETF.
An ETF that uses swaps to replicate a UK or European index, however, does not pay Stamp Duty or FTT because it is not purchasing the underlying shares of the index. If the swap counterparty (usually a bank) buys the constituents of the index to hedge the derivative contract it writes with the ETF, the bank would generally be exempt from those same taxes. This results in an up-front cost savings to the end-investor, compared to an investor in a similarly priced physical ETF on the same index.
An ETF that uses a swap-based replication method to track a global benchmark might be able to benefit from a combination of each of these tax treatments. A swaps-based ETF on the MSCI World index, for instance, should not be liable for dividend withholding tax on the US components, nor should it pay Stamp Duty or FTT on its UK and Italian and French constituents. Using swap contracts may also be a more cost-effective way to track such a large index compared to having to buy and sell all the constituents through a physical replication method. Also, as illustrated in Figure 2, a swap-based ETF may generally be expected to deliver smoother performance relative to the index being tracked, compared to physical variations.
Source: Bloomberg, 12 months to end-June 2024, in USD, average of largest swap-based and physical MSCI World ETFs in Europe. For illustrative purposes only.
Data: Invesco and Bloomberg, showing the averages of the largest swap-based and largest physical MSCI World ETFs in Europe based on AUM, to 31 October 2022. For illustrative purposes only. Past performance is not an indication of future returns.
The China A-Shares market is another case where swap-based replication can provide an advantage but, rather than coming from any tax treatment, it is due to the unusual dynamics of the market itself. The China A-Shares market tends to be a profitable environment for market-neutral strategies. However, securities lending and other hedging mechanisms traditionally used by these hedge funds are not available to them in China, so they often turn to banks to offset the risk. Banks provide these facilities (for a generous fee) and are willing to pay an ETF to take the market exposure through a swap agreement.
While in a typical market, an ETF would be expected to pay a swap fee to the counterparty, these unusual market dynamics in China may result in a negative fee, i.e., the ETF receiving the swap fee from the counterparty. When the swap fee is negative, the ETF can deliver outperformance of the index return. The amount of the swap fee – and the potential outperformance – varies over time.
Using swaps to replicate an index is not without risk, but measures can be put in place to reduce it. Aside from the common risks associated with any investment, the use of swaps introduces counterparty risk, i.e., that the swap counterparty is unable to fulfil its side of the contract. At Invesco, we seek to reduce this risk through:
Holding a basket of quality equities: Invesco’s swap-based ETFs hold a basket of equities that are different from those in the index being tracked. The basket is owned by the ETF (not used as collateral) and is expected to provide a return for the ETF. One objective of using swaps is to deliver a lower tracking error than would be possible with the basket alone.
The use of multiple counterparties: Our swap-based ETFs can have up to six counterparties, which reduces the potential financial impact on the ETF if any one counterparty defaults. We only select counterparties with high credit ratings, regularly monitor these and stress-test potential risk scenarios.
Resetting the swaps: The value of the swap, known as the mark-to-market, is reset to zero whenever certain conditions are met, such as when there is a creation/redemption in the fund, or the mark-to-market value exceeds a strictly defined level. These frequent resets are intended to limit the amount of counterparty risk.
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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.
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Views and opinions are based on current market conditions and are subject to change. Issued by Invesco Investment Management Limited, Ground Floor, 2 Cumberland Place, Fenian Street, Dublin 2, Ireland.
