Passive investing is often viewed as simple: pick a benchmark and track it as closely and cheaply as possible. But underneath this simplicity lies a crucial decision: how to replicate the benchmark. The choice between the two routes, physical and synthetic replication, can have meaningful implications for performance, costs and risks to a portfolio.
While most investors intuitively lean toward physical ETFs, which hold the index's underlying securities, synthetic ETFs are regaining some interest amongst investors and allocators. In some cases, they offer cleaner, more tax-efficient and lower-friction exposures than their physical peers. As regulations have evolved and transparency has improved, synthetic replication deserves renewed consideration, especially for equity allocations in certain markets, where it may even prove to be the superior choice.
What is synthetic replication?
Physical ETFs hold the actual securities from the target index, either fully or, a via a cross section of them to achieve the index return. In contrast, synthetic ETFs use derivatives, Total Return Swaps (TRS), to replicate the index performance. In a TRS, the ETF enters a swap agreement with a counterparty (usually a bank), which agrees to pay the fund the index return. In return, the ETF purchases and delivers the return on a segregated basket of substitute securities that it holds.
This setup allows the ETF to mirror index performance without owning its underlying components, unlocking several advantages in specific markets.
From suspicion to sophistication
After the 2008 crisis, synthetic ETFs faced heavy scrutiny due to counterparty risk: the chance that the swap provider could default on their side of the agreement. Back then, oversight and risk mitigation were weaker and, as a result, synthetic ETFs fell out of favour. Since then, however, the landscape has changed.
- UCITS regulation limits counterparty exposure to 10% of NAV. However, most providers mark-to-market and reset swaps at daily and at much lower thresholds, staying well below the cap.
- Collateralisation is standard: issuers have strict controls on what is allowed into collateral baskets, and these are segregated, daily valued and often over-collateralised.
- Multi-swap platforms spread risk across counterparties, reducing risk.
In addition, leading synthetic ETF providers now disclose collateral and counterparty exposures daily, often exceeding the transparency levels of physical ETF peers.
Securities lending: levelling the playing field
One criticism of synthetic ETFs was their inherent counterparty risk, which wasn’t present in physical ETFs. Ironically, however, with fee levels dropping so low, reducing the ability for physical ETFs to differentiate themselves, many physical ETFs now engage in securities lending, loaning out stocks to short sellers to bolster returns, but also introducing counterparty and operational risk. Though these programmes are also often over-collateralised and managed well, the risks are conceptually similar to those found in synthetic structures. This convergence has narrowed the perceived risk gap between synthetic and physical ETFs.
Investors wary of synthetic ETFs for counterparty risk should be applying the same scrutiny to their physical ETFs engaged in securities lending programmes.
Where synthetic ETFs make sense
Although synthetic replication is now growing, it should be pointed out that it isn’t ideal for every index. Swap contracts mean additional costs beyond fund TERs, and these can fluctuate. However, in specific markets, the structural advantages of synthetic ETFs can lead to outperformance, and we are now seeing ETF issuers targeting these cases more deliberately, with their synthetic offerings.
US equities: withholding tax efficiency
US equities offer a compelling case. The market is extremely liquid and efficient, and fees are minimal, however, even here, physical ETFs can be at a disadvantage.
- An Irish-domiciled physical ETF pays a 15% withholding tax on US dividends due to the US-Ireland tax treaty.
- A Luxembourg-domiciled physical ETF pays 30%, putting it at a further disadvantage.
- A synthetic ETF, by contrast, receives the index’s total return via swap, dividends included, without physical receipt, thus avoiding withholding tax altogether.
Given the S&P 500’s approximate 1.5% yield, in 2024, physical ETFs lose 22–45 basis points annually to withholding tax, whilst synthetic ETFs avoid this entirely. Over time, this can significantly impact performance.
China A-Shares: benefiting from market structure
Normally, synthetic ETFs trade tracking error improvements for tracking difference impacts, due to swap costs, which can result in slightly lower overall performance compared to physical peers. But China’s partially-closed onshore financial markets mean this trade-off can be mitigated.
Foreign investors face strict rules and access constraints in the onshore (A-shares) market. To implement long / short strategies, hedge funds rely on authorised banks and brokers to facilitate their strategies. These institutions, often then long A-shares exposure, seek to offload their risk via total return swaps. Synthetic ETFs, as natural swap counterparties, can therefore negotiate extremely attractive terms.
As a result, synthetic China A-share ETFs have historically been able to benefit from “index return + ~500bps,” swap costs, although more recently this has dropped to “index + ~250bps.” This turns the swap cost into a net gain, creating potential outperformance over physical ETFs.
Emerging markets: minimising frictional costs
Emerging markets involve high trading frictions: financial transaction taxes (FTT), capital gains taxes (CGT) and various other inefficiencies, make investing in this asset class a higher cost endeavour. Physical ETFs face these headwinds directly, due to having to buy direct equities in the various markets and regions, but synthetics in many cases don’t. India is a notable example:
- Physical funds suffer a 12.5% CGT on redemptions of positions held over a year.
- Synthetic ETFs domiciled in Luxembourg (as an example) avoid this CGT entirely.
To improve their optical tracking performance, some physical ETF issuers don’t accrue CGT liability in their NAVs. Instead, they apply it at redemption, on a net return basis. Even so, physical ETFs would still lag synthetic ones in a rising market, all else being equal. Similar issues to those in India are present in Taiwan, South Korea, and Brazil, which, together with India, form over 50% of the MSCI Emerging Markets Index. By avoiding many of these taxes, synthetic ETFs often deliver better tracking error (how tightly they follow the index) and better tracking difference (how closely they match index returns) in emerging market regions.
From alternative to advantage
Synthetic replication has evolved from a niche workaround for difficult to access markets, to now being a performance-driven option. In markets like US equities, China A-shares, and emerging markets, synthetic ETFs can offer tax benefits, cost savings, and improved tracking versus physical peers.
At AJ Bell, we introduced synthetic ETFs alongside physical ETFs into our Emerging Markets ex-China and China allocations in January 2025. In the case of EM ex-China, this is due to the frictions and higher costs associated with investing in these regions, whilst in the case of China, where the MSCI China Index includes an approximate 20% A-Shares weighting, we can inherit some of the significantly positive swap spreads on offer in the China A-Shares market, to help improve performance.
Though synthetic replication carries risks, better operational processes and oversight, combined with increased transparency, and physical ETFs engaging in securities lending, mean the lines are being blurred as to the level of that additional risk. Choosing between physical and synthetic replication is no longer simply about avoiding this, but instead optimising for after-cost and tax returns, relative to an investor’s goals and, as highlighted, in some specific markets, that answer may well be best served by synthetics.
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Past performance is not a guide to future performance, and some investments need to be held for the long term.
