Why Are Synthetic ETFs Garnering So Much Interest?

There’s no denying the popularity of the exchange-traded fund (ETF), not only in the United States, but on a global scale. In places like Europe, synthetic ETFs are gaining in popularity, but what’s garnering this interest?

ETF provider Invesco sheds some light on why that could be the case despite a challenging 2020.

“In the first nine months of 2020, we’ve seen $1.5bn (€1.28bn) of net inflows,” says Gary Buxton, Head of Emea ETFs and Indexed Strategies at Invesco, in an Expert Investor article. “While the rest of the synthetic market has seen net outflows.”

Per Investopedia, a “synthetic ETF is an asset designed to replicate the performance of an underlying index using derivatives and swaps rather than physical securities. Providers enter an agreement with a counterparty – usually an investment bank – that ensures future cash flows gained by the underlying benchmark are returned to the investor. In other words, the synthetic fund tracks the index without owning any physical securities.”

Synthetic ETF Advantages

As far as any advantages synthetic ETFs have over traditional ETFs that hold securities, Investopedia noted that supporters of “synthetic funds claim they do a better job of tracking an index’s performance. It provides a competitive offering for investors seeking access to remote reach markets, less liquid benchmarks, or other difficult to execute strategies that would be costly for traditional ETFs to operate.”

“[But] tracking difference or tracking error is not correlated so much to whether an ETF is swap-based or physical, but instead to how well the product is managed overall. A well-managed physical ETF will track its index very closely,” said Sidi Kleefeld-Von-Wuestenhoff, Head of ETF Advisory Sales at DWS.

“Critics of synthetic funds point to several risks, including counterparty risk, collateral risk, liquidity risk, and conflicts of interest,” Investopedia explained further. “In many cases, it’s uncertain if both parties will live up to their side of the obligation. Using collateral can help mitigate risks tied to default and the other parties.”

Another advantage relates to taxes. ETFs in general already provide tax advantages versus mutual funds, but synthetic funds take this advantage to another level.

“Jose Garcia Zarate, associate director, passive strategies, manager research, Europe at Morningstar, explains to Expert Investor that, in the specific case of US large cap equity markets, synthetic ETFs outperform physical ETFs because of their tax advantage,” the article explained.

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