The market share of synthetic ETFs has been in seemingly terminal decline since a succession of crises around 2010 brought counterparty creditworthiness into question.

In certain pockets such as US equities, however, the structure is making a resurgence.

Improvements in the swap model, better collateralisation, diluted counterparty risk and above all superior performance are attracting investors back to synthetic ETFs. Issuers are looking to capitalise.

Invesco is chief advocate for synthetic ETFs in Europe while BlackRock – traditionally opposed to this methodology – performed a dramatic volte face in 2020 with the introduction of a swap-based S&P 500 ETF.

State Street Global Advisors (SSGA), yet to launch a synthetic equity ETF, is now considering an entry to the space.

Matteo Andreetto, head of intermediary client coverage – Europe, told ETF Stream that “while I can’t disclose specific product plans, the rise of swap-based ETFs reflects a broader trend: the growing sophistication of investors and their demand for tailored solutions in different regulatory and market environments.”

“Investors should always expect SSGA to provide the best solution for their needs.”

Indeed, as the below chart illustrates, Europe-domiciled synthetic ETFs held over $250bn in assets under management (AUM) as of 28 November, according to data from ETFBook.

Chart 1: Europe-domiciled synthetic ETF AUM by asset class, 2015-present

Source: ETFBook

With demand for synthetic products growing, there is little surprise that ETF providers are looking to secure a slice of the pie.

The “replication war” and the fall of synthetic ETFs

According to data from Morningstar Direct, in 2010 46% of passively-managed equity assets were held in synthetic ETFs. A series of financial crises, however, brought counterparty risk to the fore and sparked an exodus from the structure. Today that figure stands at just 13%.

Chart 2: Passive equity AUM by replication method, 2004-present

Source: Morningstar Direct. Active equity ETF assets have been excluded from the data since synthetic replication does not apply to them.

At this time, most synthetic products did use the theoretically safer ‘unfunded’ total return swap model, but they tended to be heavily exposed to a single counterparty – often the issuer’s parent company – and ‘protected’ by substitute baskets that were opaque and unfit for purpose.

As Jose Garcia-Zarate, associate director of manager research at Morningstar, put it: “The issue was not so much that the substitute baskets were different to the index, but there was a suspicion that the investment banks were chucking anything in there that they didn't want to have on their books.”

A succession of crises around 2010 precipitated a “replication war”. Vocal critics like BlackRock fulminated against the big synthetic providers of the time like Amundi, DWS and Lyxor – the latter now part of Amundi.

Indeed in 2011, BlackRock CEO and chairman Larry Fink said: “if you buy an Lyxor product, you are an unsecured creditor of SocGen.”

Regulators such as the International Monetary Fund (IMF) and the Bank of International Settlements (BIS) also issued warnings about swap-based ETFs further tarnishing their reputation.

As a result investors pulled assets from synthetic products en masse. €3.2bn left swap-based equity ETFs in 2013 alone, according to Morningstar Direct data, and their share of AUM fell significantly. Providers were forced to switch many of their products over to physical replication.

A shot in the arm for synthetics

In certain areas like US equities, however, swap-based ETFs have been on the comeback trail. As the below chart illustrates, between 2017 and 2019 the share of S&P 500 tracker AUM using synthetic replication jumped from 17% to 30%.

Chart 3: S&P 500 ETF AUM by replication method, 2014-present

Source: Morningstar Direct.

This followed 2017 regulation allowing the total return of an index to be calculated free of withholding tax on US dividends. This gave synthetic ETFs an inherent tax advantage over their physically replicating counterparts. The latter must pay 15% on US dividends if domiciled in Ireland and 30% if domiciled in Luxembourg.

“Within the passive space investors are often choosing between allocations in order to save 1-2bps, and so the 20bps or so of performance uplift you can achieve by capturing the gross dividend demands consideration,” said Dan Caps, investment manager at Evelyn Partners.

Synthetic ETFs have also made big strides in terms of the safety of the underlying swap structures, according to Garcia-Zarate.

The riskier ‘fully funded’ swap model is now largely a thing of the past and “instead of relying on just one counterparty they typically spread the risk across multiple. The quality controls for the assets used in reference baskets have also improved massively,” he added.

Swaps typically mark-to-market daily, too, and if counterparty exposure – the difference between the value of the reference basket and the ETF’s net asset value (NAV) – creeps above the 10% limit for UCITS, the swap resets and the counterparty is forced to place additional securities into the reference basket.

In practice this rarely happens, however, as many providers choose to reset counterparty exposure to zero on a daily basis.

While “counterparty risk remains an important consideration, particularly in stressed market environments, the industry has made significant progress in mitigating it. Synthetic ETFs are more robust than they were in the early 2010s,” commented Nathan Sweeney, CIO of multi-asset at Marlborough.

More providers to enter the fray?

As investors re-engage with synthetic ETFs, issuers are increasingly looking to position for the coming flow – just as BlackRock’s U-turn demonstrates.

For Andreetto of SSGA, however, “the real story isn’t just about replication methodology, but how ETF providers are navigating a rapidly changing investment landscape to deliver value.

“It’s no longer just about tracking an index – it’s about doing so in ways that anticipate client needs and regulatory shifts.”

Perhaps the biggest beneficiary of this trend has been Invesco. Although it still lags Amundi in terms of assets, as the below chart illustrates, it has been Europe’s most vocal advocate of swap-based ETFs and as such the space’s chief flow-generator.

Chart 4: Share of synthetic ETF AUM by provider, November 2024

Source: ETFBook

The Invesco S&P 500 UCITS ETF (SPXS) – the world’s largest synthetic ETF – has taken in about half of all flows into synthetic S&P 500 products this year, according to Chris Mellor, head of EMEA ETF equity product management at the firm.

That said, swap-based ETFs are not everyone’s style. A spokesperson from Vanguard told ETF Stream that the US giant has no plans to launch any synthetic products.