How Synthetic ETFs Are Different Than Physical ETFs

Exchange traded funds (ETFs) are a cost-efficient way to access a variety of investment exposures and hence have gained much popularity among investors. To keep up with the demand for transparent, liquid, cost-effective diversified investment products, new and advanced versions of ETFs have been developed over the years.

With these innovations, ETFs have become not only more numerous and popular but also more complex. One such innovation is the synthetic ETF, which is seen as a more exotic version of traditional ETFs.

What Is a Synthetic ETF?

First introduced in Europe in 2001, synthetic ETFs are an interesting variant of traditional or physical ETFs. A synthetic ETF is designed to replicate the return of a selected index (e.g., S&P 500 or FTSE 100) just like any other ETF. But instead of holding the underlying securities or assets, they use financial engineering to achieve the desired results.

Synthetic ETFs use derivatives such as swaps to track the underlying index. The ETF provider enters into a deal with a counterparty (usually a bank), and the counterparty promises that the swap will return the value of the respective benchmark the ETF is tracking. Synthetic ETFs can be bought or sold like shares similar to traditional ETFs. The table below compares physical and synthetic ETF structures.

Risk and Return

Synthetic ETFs use swap contracts to enter into an agreement with one or more counterparties who promise to pay the return on the index to the fund. The returns thus depend on the counterparty being able to honor its commitment. This exposes investors in synthetic ETFs to counterparty risk. There are certain regulations that restrict the amount of counterparty risk to which a fund can be exposed.

For instance, according to Europe’s UCITS rules, a fund’s exposure to counterparties may not exceed a total of 20% of the fund’s net asset value. In order to comply with such regulations, ETF portfolio managers often enter into swap agreements that "reset" as soon as the counterparty exposure reaches the stated limit.

The counterparty risk can further be limited by collateralizing and even over collateralizing the swap agreements. Regulators require the counterparty to post collateral in order to mitigate the counterparty risk. In case the counterparty defaults on its obligation, the ETF provider will have a claim to the collateral, and thus the investors’ interest is not hurt. The investors are more protected from losses in the event of a counterparty default when there is a higher level of collateralization and more frequency of swap resets.

Although measures are taken to limit the counterparty risk (it’s more than in physical ETFs), investors should be compensated for being exposed to it for the attractiveness of such funds to remain intact. The compensation comes in the form of lower costs and lower tracking errors.

Synthetic ETFs are particularly very effective at tracking their respective underlying indices and usually have lower tracking errors especially in comparison to the physical funds. The total expense ratio (TER) is also much lower in the case of synthetic ETFs (some ETFs have claimed 0% TERs). Compared to a synthetic ETF, a physical ETF incurs larger transactional costs because of portfolio rebalancing and tracking errors between the ETF and benchmarks.

Tax Considerations

Capital gains taxes on synthetic ETFs may be treated similarly to other investment vehicles. However, the use of financial derivatives in synthetic ETFs can result in higher capital gains tax rates in some cases.

For example, your gains from certain derivatives may be classified as short-term capital gains which are taxed at higher rates than long-term capital gains. Meanwhile, physical ETFs can be structured in a way where taxable events are not triggered due to an in-kind exchange.

The income generated from a physical ETF is usually classified as dividend income. Be mindful that synthetic ETFs artificially generate this dividend, and the tax status of the income may vary depending on what instruments are used to generate this income.

When it comes to reporting this activity on your income taxes, you may need to track a higher amount of information for synthetic ETFs. On the other hand, physical ETFs with more traditional structures may have more straightforward reporting requirements that exclude the necessity of tracking derivative agreements.

The Bottom Line

Synthetic ETFs come in handy for investors when it's impossible or expensive to buy, hold, and sell the underlying investment in some other way. However, the fact that such ETFs involve counterparty risk cannot be ignored, and thus the reward has to be high enough to mitigate the risks undertaken.