How to improve performance
Using the example of the S&P 500, a physically replicating ETF may be able to improve performance relative to the standard net return index via certain tools or capabilities:
- The fund may be able to achieve lower withholding tax rates depending on where the fund is domiciled and what tax treaties are applicable. For example, an Irish-domiciled ETF pays 15% withholding tax on dividends received by the fund (instead of the normal 30% assumed by the net return index) due to a tax treaty between the US and Ireland.
- If the fund engages in stock lending, the level of revenue earned from the practice depends on how indemand the index stocks are for borrowing and what portion of the revenue generated is passed on to the ETF. While offering a potential boost to performance, there is counterparty risk for the stocks on loan.
- Trading more intelligently around index rebalancing and corporate actions can deliver some improvement in performance, although mistakes or misjudgements in trading can result in underperformance.
ETFs and counterparty risk
Both replication methods may have exposure to counterparty risk, if the physical model includes securities lending. The issuer of a synthetically replicating ETF can mitigate counterparty risk by resetting the swaps to zero when certain conditions are met, such as excessive market movements or changes in the NAV of the ETF. In practice, these resets may occur daily. For issuers of synthetic and physical ETFs alike, risk of default can be reduced by dealing only with creditworthy counterparties.
Structural advantages of synthetic replication
There are many benchmarks for which synthetic replication has clear structural advantages over physical replication, often resulting in material performance gains versus the index. The replication of the MSCI World Index provides a useful case study given the sheer number of stocks and countries covered. The advantage available to synthetic replication models is due to the way that tax authorities in some countries treat physical investments versus derivatives. This section focuses on three areas: US dividend taxation, European dividend taxation and Stamp Duty / financial transaction taxes.
US dividend withholding tax
The MSCI World Index is weighted by market capitalization with shares of US companies comprising approximately 64% of the benchmark, making any efficiency gains through US tax treatment much more material to the overall effectiveness of the replication model. Foreign investors in US stocks are generally subject to a withholding tax on dividends of up to 30%, although many can reduce this to 15% through the application of tax treaties as was highlighted in the case of physically replicated ETFs domiciled in countries such as Ireland.
Under US tax law, certain types of derivatives are subject to an equivalent withholding tax rate if they pass through “dividend-equivalent” payments. Specifically, when a US bank writes a swap on an index with a non-US counterparty, it is generally required to withhold US dividend tax at the same rate as would apply to a physical investment by that same counterparty.
This would seem to level the playing field between physical and synthetic replication strategies, but the same rule that imposes this tax treatment on derivatives also specifies certain exemptions, and the MSCI World Index meets the criteria for these exemptions. Namely, section 871(m) of the HIRE Act explicitly excludes swaps written on indices with deep and liquid futures markets from the requirement to pay dividend withholding taxes.
This means that, while a European-domiciled physically replicating ETF will generally be able to achieve a maximum of 85% of the dividend yield of the US holdings in their MSCI World portfolio, a synthetically replicating ETF can achieve up to 100% of the full gross dividend amount. With an average dividend yield for US large-cap stocks of approximately 2%, this exemption means synthetically replicating funds can potentially achieve up to 30 basis points of additional performance on US exposures, which equates to around 19 basis points on the MSCI World Index.
We can see the impact of this difference more clearly if we look at ETFs tracking a US-focused bench-mark such as the S&P 500. The following chart shows the one-year performance of the five largest S&P 500 ETFs listed in Europe, two of which use physical replication and three which use synthetic. In figure 2, the dark blue line shows the average performance of the three synthetic funds while the light blue line shows the average of the two physical funds. All five funds outperform their benchmark, the S&P 500 Net Total Return Index, which assumes a 30% withholding tax rate. However, the average of the synthetic funds is 26 basis points higher than the average of the physical funds over the one-year period, in line with expectations.