Synthetic ETFs Delivered Strong Outperformance Versus Physical ETFs During COVID-19 Volatility

Dubai, United Arab Emirates, 15 October 2020:  Synthetic ETFs offering exposure to core US and global equity benchmarks have delivered strong outperformance with lower tracking errors compared to physical ETFs over the last twelve months, according to a recent analysis by Invesco. This period captures two contrasting market conditions, covering both the sharp equity market sell-off during March and April, which marked the height of the Covid-19 crisis, as well as the subsequent rally since May. 

Synthetic ETFs are designed to replicate the return of an index using derivatives such as swaps and futures to get desired exposure rather than holding the underlying securities as with physical ETFs.  Both synthetic and physical replication aim primarily to match as well as possible the performance of a specific index. Synthetic ETFs are exchange-listed and can be bought and sold as shares similar to physical ETFs.  

An analysis by Invesco looks at the performance and market flows related to the S&P 500, MSCI USA and MSCI World Indices. According to the data, leading synthetic ETFs tracking core S&P 500, MSCI USA and MSCI World benchmarks have, on average, outperformed the largest physical competitors by 0.26%, 0.19% and 0.08% respectively over the year to the end of August.  Over the past three years, these figures are 0.73%, 0.52% and 0.14%, underscoring the long-term relative outperformance of synthetic products.

Christopher Mellor, Head of EMEA ETF Equity & Commodity Product Management at Invesco, said: “The use of synthetic ETFs offers access to certain markets, given the inherent benefits available through these products versus physical equivalents. These benefits include the potential to generate consistent outperformance with low tracking error even in difficult market conditions.”

The low tracking error offered by synthetic products was brought into sharp focus in the crisis period, with tracking errors for physical MSCI World ETFs doubling to 0.10% between 31 January and 30 April 2020. In contrast, Invesco’s analysis found that synthetic ETFs maintained their lower volatility relative to the market throughout this period. 

Alessio Cirillo, Sales Director at Invesco EMEA, said: “Clients in the GCC continue to use ETFs to gain low cost exposure across sectors both opportunistically, and as part of their longer-term strategic asset allocation. Irrespective of the replication method – whether synthetic or physical - or investment style, it is important to have robust risk-management processes in place. There are several measures that an ETF provider can put in place to mitigate risk, including frequent swap resets, dealing only with creditworthy counterparties, or using a multiple swap counterparty model which could reduce the impact of any one counterparty defaulting.  Investors should understand the various risks with each replication method and select which one is most suitable for their needs.”

In contrast to physical ETFs, synthetic products use swaps to deliver a more efficient replication of an index. Under US tax law, swaps written on indices with deep and liquid futures markets, e.g. the S&P 500, are not required to pay withholding taxes on dividends. While a European-domiciled physically replicating S&P 500 ETF will generally be able to achieve a maximum of 85% of the dividend yield, a synthetic fund may theoretically achieve up to 100% of the full gross dividend amount. 

With the S&P 500 yielding around 1.9% (2% on average over the past decade), this exemption means synthetic funds could potentially achieve up to 30 basis points of additional performance each year.

Alessio Cirillo added: “Cost is another factor that tends to favour ETFs in general but especially synthetic models.  Synthetic ETFs do not hold the underlying constituents of an index thus transaction costs are reduced when rebalancing the portfolio.”