This marketing communication is for professional investors only. Investors should read the legal documents prior to investing.

Synthetic ETFs are garnering attention as a compelling alternative to traditional physical ETFs as investors become increasingly aware of potential cost and market access advantages.

In a discussion in partnership with Invesco, Jordan Sriharan, fund manager, Canada Life Asset Management, Weixu Yan, head of passives, Close Brothers Asset Management and Chris Mellor, head of EMEA ETF equity product management at Invesco, discussed tracking accuracy, accessing hard-to-reach markets and the withholding tax efficiencies of swap-based (synthetic) ETFs tracking certain US indices.

What is the case for synthetic replication and in which markets does it work best?

Mellor: There are three reasons why we choose to launch on a synthetic platform. The first is performance. In some markets, you can potentially get a significant performance advantage. In others, you can reduce trading costs through using a swap-based ETF.

The second reason is tracking error. That is especially relevant for more difficult to track, less liquid markets like emerging markets where a swap-based ETF is going to work well at tracking the benchmark whereas a physical ETF may have more volatility in tracking performance.

The third is around difficult to access markets and again, that primarily applies to emerging markets, where effectively using swap-based approaches outsources the index replication to large swap counterparties who may already have operations in difficult to access markets.

Yan: Previously, synthetic ETFs were slightly more expensive, but they have come down to broadly the same levels as the physical. We have been doing some analysis because of the withholding tax advantages.

We have been buying some of the synthetic ETFs in emerging markets as they provide generally better tracking in harder-to-access markets compared to physical ETFs.

Sriharan: We focus on structures that provide the most efficient exposure. In developed markets (DM) where active management has struggled to outperform passive and where we are more comfortable with longer term exposures, we started to naturally research more efficient products which has led us to look at synthetics.

Lower fees, improving performance and lower tracking error are reasons why synthetics are something we are looking to utilise more within DM equities.

There have been significant flows into US equities, including through synthetic ETFs. What makes implementing this exposure through such a vehicle attractive?

Mellor: The performance advantage of swap-based ETFs in the US is due to the withholding tax advantage. Standard investment in US equities would attract a 30% withholding tax on all dividends paid by the companies in the portfolio. For certain jurisdictions or domiciles, this can be reduced with a physical fund.

For example, an Irish-domiciled physical ETF that meets all the requirements can reduce that to a 15% withholding tax rate. But for a swap-based approach, the swap counterparties to the ETF can receive dividends with zero withholding tax, achieving gross performance on the hedge they hold for the swap, and they can pass that through to the ETF itself.

One concern with synthetics after the Global Financial Crisis (GFC) was counterparty risk. How has this developed in recent years?

Mellor: Counterparty exposure is a key risk for a swap-based ETF. The first thing to clarify is that we are not talking about the whole value of the ETF being exposed to the swap counterparty. We employ an unfunded swap model, where the ETF buys a basket of equities and swaps the performance of that basket for the performance of an index.

But the ETF’s value is primarily tied to the basket of equities that is wholly owned by the fund. The only time you get swap counterparty exposure is when the index outperforms the basket and now the swap counterparty owes you the amount of that difference in performance.

There are two ways you can mitigate that. One is collateralisation, which is required by EU regulations for exposure above €500,000. The alternative – and our preferred approach – is to reset the swaps when the exposure goes above tight trigger levels. Reset is a much cleaner way and takes out any complications of collateralisation.

How important is the total cost of ownership when you are investing in any ETF, particularly synthetic ETFs?

Yan: Within the total cost of ownership, we look at the bid-ask spread. That is why the S&P 500 looks great on the investment side due to its large size and tradability. We also factor in swap costs. These costs come into play; however, we receive the performance net of fees anyway.

If we can see the net of fees outperform consistently against the benchmark, despite, let us say 10 basis points (bps) of swap fees and they still managed to outperform the benchmark by 20-30bps, you are still winning there.

Sriharan: As the ETF world evolves with the onset of active and smart beta ETFs, the headline fee becomes relatively important. We will struggle to replace our current allocation of passive ETFs on a purely cost basis, because we are pushing up the overall price of our underlying multi-asset funds.

It is important to look at those underlying tracking error differences. But the headline fee is an important driver of how we bring our overall costs down, which is ultimately what the regulator is imposing from a multi-asset perspective. We are conscious of that number that goes into our total expense ratio (TER).

Is there a worst-case scenario with synthetic ETFs? Do you have any examples of how they performed in stress markets such as COVID-19?

Mellor: The worst-case scenario is that a counterpart defaults on the swap when the index has outperformed the basket since the last reset. Under that scenario the amount of exposure you have could be lost, or it could take a long time to reclaim through the bankruptcy process. We have a strict approach to reset swaps when counterparty exposure goes above tight trigger levels, reducing the risk of this unwanted outcome.

The most difficult market environment we have been through since launching the ETFs on our platform more than 15-years ago, was the COVID crisis, with significant volatility in the markets. What we saw from synthetics was exactly what you would have hoped – continued tight tracking of benchmarks throughout that period of volatility.

Aside from the US withholding tax advantage, are there any markets where a synthetic approach is particularly attractive for fund selectors?

Mellor: The obvious example is China’s onshore equity market – China A-shares. Typically, in a US exposed swap-based ETF, what you see is about 20 to 25bps of outperformance irrespective of how low the fees are.

However, if you look at China, we are talking about 300 to 800 basis points of annualised outperformance in large and mid-cap exposure through the swaps over the past five years. That is not due to withholding tax but due to a market structure question, which basically restricts stock lending in China A-shares and results in an additional returns for an ETF investor through a negative swap fee.

Explore Invesco’s swap-based ETF range: When synthetic benefits become real

Past performance does not predict future returns. Source: Bloomberg, 31 Oct 2024. The table shows performance over the past 10 years to the most recent month end. All securities are in USD. Invesco ETF performance is based on Net Asset Value after management fees and other ETF costs but does not consider any commissions or custody fees payable when buying, holding or selling the ETF. The ETF does not charge entry or exit fees. Each period starts at the end of the indicated month. The first indicated month may not represent a full month and may start only on the launch/restructuring date indicated above. Returns may increase or decrease as a result of currency fluctuations. An investment can't be made in an index.

Investment risks

For complete information on risks, refer to the legal documents.

Value fluctuation: The value of investments, and any income from them, will fluctuate. This may partly be the result of changes in exchange rates. Investors may not get back the full amount invested.

Emerging markets: As a large portion of this Fund is invested in less developed countries, investors should be prepared to accept a higher degree of risk than for an ETF that invests only in developed markets.

Use of derivatives for index tracking: The Fund’s ability to track the benchmark’s performance is reliant on the counterparties to continuously deliver the performance of the benchmark in line with the swap agreements and would also be affected by any spread between the pricing of the swaps and the pricing of the benchmark. The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose the Fund to financial loss.

Concentration: The Fund might be concentrated in a specific region or sector or be exposed to a limited number of positions, which might result in greater fluctuations in the value of the Fund than for a fund that is more diversified.

Equity: The value of equities and equity-related securities can be affected by a number of factors including the activities and results of the issuer and general and regional economic and market conditions. This may result in fluctuations in the value of the Fund.

Synthetic ETF Risk: The Fund might purchase securities that are not contained in the reference index and will enter into swap agreements to exchange the performance of those securities for the performance of the reference index.

Currency: The Fund’s performance may be adversely affected by variations in the exchange rates between the base currency of the Fund and the currencies to which the Fund is exposed.

Important information

This marketing communication is exclusively for use by professional investors in Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the UK. It is not intended for and should not be distributed to the public.

Data as at 18 December 2024, unless otherwise stated.

By accepting this material, you consent to communicate with us in English, unless you inform us otherwise.

This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.

Views and opinions are based on current market conditions and are subject to change.

For information on our funds and the relevant risks, refer to the Key Information Documents/Key Investor Information Documents (local languages) and Prospectus (English, French, German), and the financial reports, available from www.invesco.eu. A summary of investor rights is available in English from www.invescomanagementcompany.ie. The management company may terminate marketing arrangements.

UCITS ETF’s units / shares purchased on the secondary market cannot usually be sold directly back to UCITS ETF. Investors must buy and sell units / shares on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current net asset value when buying units / shares and may receive less than the current net asset value when selling them. For the full objectives and investment policy please consult the current prospectus.

Index disclaimer: The S&P China A 300 Index and S&P China A MidCap 500 Index are products of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”), and have been licensed for use by Invesco. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Invesco. The Invesco S&P China A 300 Swap UCITS ETF and Invesco S&P China A MidCap 500 Swap UCITS ETF are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, or their respective affiliates and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P China A 300 Index and S&P China A MidCap 500 Index.

Issued by Invesco Investment Management Limited, Ground Floor, 2 Cumberland Place, Fenian Street, Dublin 2, Ireland. Regulated by the Central Bank of Ireland.

Belgium: This product is offered in Belgium under the Public Offer Exemption. This material is intended only for professional investors and may not be used for any other purpose nor passed on to any other investor in Belgium. Switzerland: Issued by Invesco Asset Management (Schweiz) AG, Talacker 34, 8001 Zurich, Switzerland. The representative and paying agent in Switzerland is BNP PARIBAS, Paris, Zurich Branch, Selnaustrasse 16 8002 Zürich. The Prospectus, Key Information Document, and financial reports may be obtained free of charge from the Representative. The ETFs are domiciled in Ireland. Germany: German investors may obtain the offering documents free of charge in paper or electronic form from the issuer or from the German information agent (Marcard, Stein & Co AG, Ballindamm 36, 20095 Hamburg, Germany). Italy: The publication of the supplement in Italy does not imply any judgment by CONSOB on an investment in a product. The list of products listed in Italy, and the offering documents for and the supplement of each product are available: (i) at etf.invesco.com (along with the audited annual report and the unaudited half-year reports); and (ii) on the website of the Italian Stock Exchange borsaitaliana.it.

EMEA 4107627/2024