If you sort the ETFs that track US indices by performance and look at the replication method of the top ones, you will see a clear trend: all of the best performing ETFs are synthetic ETFs.
Check the list of S&P 500 ETFs, the one for the MSCI USA, or the one for the NASDAQ-100 - the top performers are swap based synthetic ETFs in every one of them.
So let's see what these funds actually are, why they perform better than ETFs with physical replication, when they make sense to hold and who should avoid them completely.
The short version: these funds legally avoid a 15% US tax that every normal ETF pays on US dividends - and that is worth roughly 0.16% per year, every single year. That sounds tiny, and it is. But on a 100,000 EUR portfolio with a 7% yearly return, over 30 years, that small difference compounds into more than 30,000 EUR.
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One quick note before we start: I use the terms synthetic ETF and swap ETF interchangeably, because in practice every synthetic ETF we are talking about here uses a swap to track its index.
What synthetic ETFs are not
In general, synthetic ETFs have a bit of a bad reputation - and I see lots of misinformation about them. So let me start by saying that they are not some kind of certificate or just a promise without real assets behind it. In fact, it's the opposite: synthetic ETFs typically also own a bucket of equities, or in some cases bonds. With a synthetic UCITS ETF you own shares of a fund, and that fund owns its assets under exactly the same rules that apply to physically replicating ETFs. The trick is that the fund doesn't own the same stocks that are in the index it tracks.
But let me also explain where this bad reputation comes from, because it is not made up. Back in 2008, during the financial crisis, a lot of people in Europe lost money on Lehman Brothers certificates - and those really were the thing that people are afraid of today: a promise from a bank, with no assets behind it. When Lehman went under, those promises were worth nothing. A synthetic ETF is not that - but the word derivative stuck, and the fear stuck with it.
Then in 2011 the Financial Stability Board and the IMF published warnings about synthetic ETFs, and in 2012 ESMA came out with its guidelines for ETFs. There was a real issue behind this: back then the swap counterparty was very often the parent bank of the ETF provider itself. Lyxor was owned by Société Générale, db x-trackers was owned by Deutsche Bank - so the same bank was essentially sitting on both sides of the trade.
Investors reacted: money flowed out of the synthetic funds and into the physical ones, and the providers gave in. Lyxor and db x-trackers started converting their funds to physical replication in 2012 and 2013. So for about a decade, synthetic replication was the thing nobody wanted to be associated with.
And this is what makes the current situation interesting. In 2020 BlackRock - the biggest ETF provider in the world, and for years a vocal sceptic of synthetic ETFs - launched the iShares S&P 500 Swap UCITS ETF. That was a real U-turn. And the conflict of interest problem from back then is gone as well: the counterparties of that fund are external banks, and there is more than one of them.
The substitute basket
Let's take a concrete example: the Invesco S&P 500 UCITS ETF, which is a synthetic ETF. If you go to the provider's website and look at the holdings, you'll first see the top 10 exposures of the fund - these are the top 10 positions of the S&P 500. But these are not the positions the fund actually holds. If you scroll further down, you'll find the basket constituents - this is the so-called substitute basket, and these are the real positions in the fund.
If you put the two lists side by side, you'll see they are not the same. And if you dig deeper into the substitute basket, you'll even find securities that are not part of the S&P 500 at all.
So how is the index tracked? The swap counterparty
So synthetic ETFs hold real securities - but different securities than the index they track. The natural question is: how do they follow that specific index without holding its components in the proper weights?
This is where the swap counterparty comes into play. These ETFs have a contract, typically with an investment bank, and that contract basically says: the swap counterparty delivers the return of a specific index (in our case the S&P 500), and the ETF delivers the return of its seemingly random substitute basket. There is a difference between the returns of these two things - and the agreement is that they swap that difference.
These counterparties are not anonymous entities somewhere in the background - the providers publish who they are. For the iShares S&P 500 Swap ETF, for example, the swap counterparties at the time of writing are JP Morgan and Citi. And note the plural: funds typically work with several counterparties at the same time, so the exposure is split up instead of sitting with one single bank.
For the synthetic ETF this means that the performance of the substitute basket doesn't really matter, because the fund periodically swaps the difference with the counterparty. The net exposure of the fund is the actual index, not the securities it holds.
Funded vs. unfunded swaps
There is a nuance here that often leads to confusion: unfunded vs. funded swap ETFs. Most of the UCITS ETFs that Europeans hold are so-called unfunded swap ETFs. The word "unfunded" once again sounds like something less safe than "funded" - but that's not really the case.
Ultimately, the investors of the fund - so the owners of the synthetic ETF - provide the money that gets exposed to the tracked index. Funded vs. unfunded basically describes who holds that money.
- Unfunded swap: the fund itself buys and holds the securities, and only the difference between the return of the substitute basket and the return of the tracked index is swapped between the fund and the counterparty. This is what we described above, and it's the widely used structure in the UCITS world - so in practice, this is what European investors typically end up with.
- Funded swap: the swap counterparty ends up holding the investors' money. Here your fund really just owns a claim against a counterparty - a promise, backed by collateral. There are safety mechanisms here as well around who holds the collateral and how it is segregated, but that doesn't matter much for our discussion, because only very few UCITS ETFs marketed to European investors use this structure.
Why all this complexity? The tax advantage
All right, so with a lot of complexity we ended up tracking indices that are trivial to track by just owning their components outright. So why does this whole thing make sense? The answer is tax savings - and this is the reason swap ETFs typically outperform ETFs that hold the index components directly.
To understand why this works, let's first look at how a normal ETF is taxed.
ETF investments are taxed at two levels:
- The fund level. The fund itself may pay taxes, and those are the same for every single investor in the fund. This is what's reflected in the returns the fund provider reports.
- The personal level. This depends on the country where you are taxed, and in some countries special accounts are taxed differently than normal ones. The ETF provider doesn't know any of this, and none of the returns it reports include these taxes.
If you invest in equities - and that's what we are talking about here - your returns come from two things:
- Capital gains, meaning the value of the shares owned by the ETF grows; and
- Dividends, meaning companies distribute money to their shareholders.
Capital gains are typically taxed at the personal level, and the ETF provider doesn't have much to do with it. Dividends are different: an ETF owns shares of many companies, some of them periodically pay dividends to the ETF - and some countries apply a so-called withholding tax, meaning taxes are withheld at the source.
The US withholding tax
Let's take a very specific example. Say you own an ETF that holds shares of The Coca-Cola Company. This can be an S&P 500 ETF, but it can just as well be one of the popular all world ETFs like the Vanguard FTSE All-World or an MSCI World ETF - it's the same story no matter which one you own. Coca-Cola, a US company, pays a dividend to the ETF - and ultimately to you as the investor.
The United States wants a part of that dividend. The default withholding tax rate is 30%: if a US company pays a dividend to a foreign entity - in this case a European ETF - then 30% goes to the US government and the ETF keeps 70%.
But of course, we are talking about taxes, so there are ways to optimize this. Some countries have tax treaties with the United States that lower the rate. Ireland is one of them, with only 15% - so if the ETF is domiciled in Ireland, 15% is withheld instead of 30%. This is why most ETFs used by European investors are domiciled in Ireland.
But 15% is still withheld - and not many people realize this. For an ETF that holds US dividend payers, 15% of the dividend income is already lost at the fund level, before you pay any tax to your own government.
How swap ETFs avoid it
Synthetic, swap based ETFs optimize this 15% further. And this is where the complexity with the substitute basket and the swap counterparty finally starts to make sense: the substitute basket typically contains companies that don't pay dividends, or that are in a country with no withholding tax on dividends - meaning not in the US. So the ETF holds shares that don't generate taxable dividend income, and to receive the return of the tracked index, it swaps the difference with a counterparty that doesn't pay the withholding tax on the dividends.
For this to work, there is an actual regulatory framework in place: Section 871(m) of the US Internal Revenue Code, together with its Treasury regulations - particularly Treas. Reg. §1.871-15.
The important part is the "qualified index" safe harbor under Treas. Reg. §1.871-15(l): a derivative referencing a qualifying broad, diversified, passive index is generally not treated as referencing the individual US stocks within that index for 871(m) purposes. This means the payment the swap counterparty makes to the ETF is not treated as a US dividend, so there is no withholding tax on it. It's important that the ETF tracks such a qualified index - if someone comes up with a random set of stocks, this may not work. It really needs indices like the S&P 500 or something similar.
What it's worth in numbers
The dividend yield of the S&P 500 is currently 1.06% - which, by the way, is extremely low compared to historical averages. The higher the dividend yield, the bigger the advantage of a swap based ETF. But for our example, let's stick with the current 1.06%.
Say you have 100,000 EUR invested in the US market, which we approximate with the S&P 500:
- You currently receive 1,060 EUR - or 1.06% - in dividends.
- With a standard, physically replicating ETF domiciled in Ireland, the US government takes 159 EUR of that - or 0.159% of your portfolio - as withholding tax.
- A synthetic ETF saves a significant portion of this. The swap structure has some extra costs, so we shouldn't assume it goes all the way to zero, but it eliminates most of it.
And one thing I'd like to emphasize: this difference compounds. The 0.159% you save in the first year keeps growing in the second year, and so on.
You can see it in the data
This is not just theory - it shows up in the data.
Take the S&P 500 UCITS ETFs and sort them by 1 year performance. In first place there is the iShares S&P 500 Swap ETF, in second place another swap ETF from Xtrackers, and after that a swap ETF from Amundi. Switch to 10 years and there are fewer ETFs with a long enough history, but the picture is the same: first the Xtrackers swap ETF, followed by the two Invesco funds, and then the Amundi swap ETF.
The MSCI USA tells a similar story. Sorted by 10 year returns, the first two ETFs have basically identical returns, and both are swap based. The Invesco one doesn't have "swap" in its name, but if you look it up, you'll see it's a synthetic ETF.
In third place there is a standard ETF with physical replication. Interestingly, the gap between the swap and the physical ETFs is very close to what we calculated in the withholding tax example above: it's roughly what you save by not paying 15% on the 1-2% dividend yield the US market had over the past decade. To be fair, part of this gap also comes from the different TERs of these funds - but the bulk of it is the withholding tax.
What about all world ETFs?
Everything so far was about the US market - on purpose, because the tax we optimize away here is the US withholding tax. But most people don't hold a pure S&P 500 ETF - they hold something like the Vanguard FTSE All-World or an MSCI World ETF. Does any of this matter for them?
Yes, because these indices are dominated by the US anyway. At the time of writing, the US makes up around 70% of the MSCI World and a bit above 60% of the FTSE All-World. So the majority of the dividends such a fund receives are US dividends - exactly the ones that lose 15% to withholding tax. The advantage doesn't disappear; it just applies to the US part of the index instead of the whole fund.
For the rest of the world, it's a lot less clear cut. Other countries have their own withholding tax rates and treaties, and whether the swap structure helps there depends on the counterparty and the specific market. So I wouldn't count on a big saving outside of the US - but as we just saw, that's the smaller part of these indices anyway.
And you don't have to build this yourself by mixing a synthetic S&P 500 ETF with something else - these funds exist. Invesco, for example, has a swap based MSCI World UCITS ETF. Note again that the name doesn't contain the word "swap" - this is one of those cases where you really have to check the replication method before you buy.
What are the risks and the downsides?
Counterparty risk
Once you know the structure, it's clear where the additional risk lies compared to a physically replicating ETF: counterparty risk. On top of the usual market risk, what you get in exchange for the optimized taxation is a counterparty your investment relies on. If it fails to deliver the difference between the return of the substitute basket and the tracked index, you can end up with a tracking error - you wanted the S&P 500, but you ended up with a set of companies that are clearly not the S&P 500.
I want to stress that this is the additional risk - it's not that you'll lose your whole investment. Sometimes I see people thinking that a synthetic ETF is some kind of derivative where all your money is exposed to the counterparty. That is not the case: if the counterparty fails, it doesn't take your money with it. What you lose is the proper tracking of the index. In theory the substitute basket could even perform better than the index, so it's not impossible that a failing counterparty would make you outperform.
On top of that, the UCITS regulation defines safety mechanisms: there is a 10% counterparty-exposure limit when the counterparty is a bank, and collateral is used to secure the ETF. In fact, most synthetic ETFs settle the swap with the counterparty daily, so the collateral is continuously adjusted to cover the current exposure.
Regulatory risk
There is a second risk, and I think it's even more important: regulatory risk. This whole advantage exists because of the qualified index safe harbor - so it exists as long as the US tax rules stay the way they are today. If that changes, the advantage is gone.
Losing the advantage itself wouldn't be dramatic. In the best case, the fund simply switches to physical replication - nothing really happens to you as an investor, you just stop collecting the extra return. The problem is the bad case: if the fund gets closed down, or merged into another fund in a way that counts as a sale for tax purposes, then your position is effectively sold and your accumulated capital gains are realized - at a moment you did not choose.
And this is where your country matters a lot more than the 0.15% we are optimizing here. If you live somewhere where capital gains become tax free after a while - the Czech Republic with its holding period test, Slovakia after holding listed securities for a year, Hungary if you hold them in a TBSZ account, and a few more like this - then such a forced realization is close to a non-event. You'd pay little or no tax on it anyway, so this is a risk you can take without thinking too much about it.
But if you are in Germany or Austria, for example, where capital gains get taxed no matter how long you held the fund, this is a real risk. What you lose there is the tax deferral you built up over years - and that deferral compounds, exactly like the withholding tax saving does. So it's very possible that one forced realization costs you more than all the withholding tax you ever saved.
Physical ETFs have counterparty risk too
One more thing that's only fair to mention: physically replicating ETFs are not free of counterparty risk either. Most big physical ETFs lend out the shares they hold. This is called securities lending, it generates some extra revenue for the fund, and it's part of the reason these funds can keep their fees so low. But it also means there is someone on the other side who borrowed those shares and has to give them back. It is collateralized and regulated, just like the swap is.
So the choice is not between counterparty risk and no counterparty risk at all - it's between a swap counterparty that is disclosed and that you can look up, and a securities lending counterparty that most people never even think about.
So, should you use swap ETFs or not?
As long as the qualified index safe harbor is in place, we can expect synthetic ETFs to outperform physically replicating ETFs. The theoretical maximum of this outperformance is defined by the dividend yield. Right now it's very low for the US market, just above 1%. Even with a 1.5% dividend yield, if we assume the swap structure completely eliminates the 15% withholding tax, the advantage would be 0.225% - and that assumes a completely free swap structure, which is very unlikely.
This number is not going to make or break your investment success. Investing regularly and not panic selling during market turbulence is far more important than a 0.225% tax advantage.
On the other hand, if you understand how these funds work, this is basically some additional return in exchange for a bit of complexity and a limited counterparty risk. I wouldn't call it free money, but it's not far from it.
A few practical things to keep in mind:
- Most synthetic ETFs are accumulating. That makes sense, since the fund doesn't really receive dividends in the first place. Distributing share classes exist for some of them, but if you specifically want income from your portfolio, or distributing funds are treated better in your country, your options are more limited.
- Don't just compare TERs. The TER is the number everybody advertises, but as we just saw, the taxes a fund pays never show up in it. The number that actually contains all of this is the tracking difference - how much the fund really lagged behind its index, or even beat it. That's the number worth comparing, and there are free websites where you can look it up for any ETF.
- Check your own country's tax rules. This can be a serious issue in some cases. Austria, for example, is particularly problematic for synthetic ETFs, because its fund tax rules can make realized gains in the ETF's substitute basket taxable - even though the ETF swaps that basket's return for the performance of the actual index. So on top of the counterparty risk, there is the risk that the ETF restructures its substitute basket and causes you a huge tax bill. In most countries such a restructuring has no tax consequences for investors, but under the Austrian rules it does. In that case, I'd say synthetic ETFs are an absolute no-go.
So before you decide, make sure there are no additional tax disadvantages in your country.
To sum it all up: synthetic ETFs are not the scary derivative products they are often made out to be. They hold real securities, they give you a small but real and compounding advantage on US dividends, and in exchange you accept a limited counterparty risk and a dependency on a tax rule that can change.
Synthetic ETFs mentioned in this article
Disclaimer
This article reflects the personal opinion of the author, and does not represent the views of any business partner, or affiliated entity.
Nothing in this article constitutes financial, investment, or tax advice. It does not take into account your individual financial situation, investment objectives, risk tolerance, or tax circumstances, and it is not a personal recommendation to buy, sell, or hold any specific financial instrument. The information is provided for general informational and educational purposes only. Before making any investment or tax decision, you should consult a licensed financial/investment advisor and a licensed tax advisor who can assess your personal situation.
Tax rules, fund structures, swap counterparties, dividend yields, index compositions, and other data mentioned in this article were accurate to the best of the author's knowledge at the time of writing but may have changed since publication and are not independently guaranteed. The description of US and national tax rules is simplified and may not apply to your situation. Past performance is never a reliable guide to future performance.
The author accepts no liability for any loss arising from the use of, or reliance on, the information in this article.
