Up until 2011, synthetic index replication was widely used in the European ETF industry and investors appreciated the low tracking errors and, in some cases, higher performances of these products compared to ETFs which used so-called physical replication. But in the aftermath of the financial crisis and the euro crisis, critics argued that ETFs that use a swap to replicate their underlying indices add another layer of risk to their portfolio. With the developments during the financial crisis in mind, investors started to divest from synthetic ETFs and invested in physical ETFs which replicate their index by either holding all the constituents of the index with the respective weight in their portfolio (full replication) or, for indices with a large number of constituents or very complex/exotic indices, a basket of securities that matches the risk/return profile of the index (optimized replication). The preference for physical replication can clearly be seen in the market shares, measured by assets under management, for the respective replication methods.
As Graph 1 depicts held ETFs which were using physical replication, 83.85% (41.77% full replication, 42.08% optimized replication) of the overall assets under management in the European ETF industry at the end of August 2020 were physical ETFs, while synthetic ETFs accounted only for 14.05%.
Graph 1: Market Share of Replication Methods by Assets Under Management (August 31, 2020)
Source: Refinitiv Lipper
Beside institutions like the International Money Fund (IMF) and the Financial Stability Board (FSB), Larry Fink, the chairman and CEO of BlackRock, the parent company of iShares, was one of the most prominent critics of synthetic ETFs. In line with this view on synthetic ETFs, iShares replaced where possible (physical replication can’t be used for all asset classes, as per UCITS legislation) its synthetic ETFs with products using physical replication.
All of a sudden, we witnessed the launch of a synthetic ETF (iShares S&P 500 Swap UCITS ETF) on the S&P 500 index by iShares on September 29, 2020. In light of its position on synthetic ETFs in the past, this move by iShares came as a surprise for me.
Nevertheless, I appreciate that the largest ETF promoter in Europe has returned to synthetic replication, as this will lead to new product innovation since synthetic replication enables the promoters to offer products on highly complex indices or for markets that can’t be accessed otherwise. For example, we will witness an increase in the number of markets available to European investors. Also, we might see lower average management fees in the future because synthetic ETFs have the potential to bring down management fees in markets where we see above average fees due to the complexity of the underlying indices and/or asset classes.
Graph 2: Average Total Expense Ratios (TER) by Asset Type and Replication Method (August 31, 2020)
Source: Refinitiv Lipper
That said, the move from iShares toward synthetic replication was from my point of view mainly driven by the fact that investors started to use synthetic ETFs more widely because they appreciate the advantages of this replication method offers even in non-complex markets such as the S&P 500. A synthetic ETF has tax advantages over physical replication. For example, a synthetic ETF can replicate a total return index (which is favorable compared to capital or net return indices from an investor’s point of view). In addition, investors also appreciate the high replication quality with regard to the risk/return profile of the underlying index.
It is also noteworthy that the construction of swaps has changed a lot since 2011. For example, in most cases the risks coming from the swap counterparty have been minimized. Additionally, securities lending, a management technique which is often used to offset management fees or other costs and therefore to boost returns of physical replicating ETFs, is coming under scrutiny by a growing number of investors. This puts additional pressure on the returns of ETFs using physical replication.
Nevertheless, one needs to bear in mind that the move from iShares and possibly other ETF promoters in Europe will add a new layer of complexity to the European ETF market. These new products come into addition to existing ones and will not replace them in the foreseeable future, even if they track the same index. This will lead to an increasing number of ETFs on the same indices. Since this will drive competition, investors should expect a higher tracking quality and lower fees for investments in these indices. Conversely, an increasing number of synthetic ETFs will also lead to an increasing number of swap constructions, which will demand more qualitative research to evaluate the risks within these contracts. Therefore, investors will need to be careful when they select ETFs for their portfolios, as there is a risk that they may choose a product that does not suit their needs and/or risk profile even if they want to invest in a plain vanilla market.
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The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.
