When does a swap-based approach gain an advantage?

People in the ETF industry have moved away from debating whether a physical or swap-based replication method has a blanket superiority. The more sensible discussion is around the circumstances under which one method could offer some advantage over the other. The choice in some cases may simply come down to investor preference, with outcomes broadly similar. However, we can identify certain situations where using swaps could offer a meaningfully superior outcome, due to favourable tax treatment or attractive swap economics.

A quick introduction to swap-based ETFs

Passive ETFs aim to replicate a specific index and will use one of two main methods to do this. A physical ETF will buy and hold the constituents of the index, in the same proportion as the index, whereas a swap-based ETF will buy a basket of securities, not necessarily constituents of the index, and use swaps to match up performance with their investment objective. Swaps are over-the-counter contracts where two parties agree to exchange (or swap) specific cash flows.

For example, a swap between an ETF and a bank would typically involve the ETF purchasing a basket of securities from the bank and agreeing to exchange the returns from that basket for the returns of the index the ETF is tracking. The ETF would normally pay a swap fee to the bank. 

A couple of points worth noting: the ETF manager has the final say on the securities going into the basket, and they will probably be different from those in the index being tracked. The primary objective of a swap-based approach is to deliver a more accurate return, and potentially an improved return, than would be possible with physical replication alone.

In general, you can usually expect the performance of a swap-based ETF to be:

                      = (Index return – swap fee) – the ETF’s annual management charge

OK, now let’s get onto the cases when a swap-based ETF may actually outperform the index.

Case 1: Structural advantage due to tax treatment

A swap-based ETF could have a structural advantage over physical ETFs in some markets due to local tax regulation or other factors. One of the clearest examples is in the US, where an ETF domiciled in Europe does not have to pay tax on the dividends when it uses equity derivatives such as swaps to track the index. This exclusion applies only to broad equity indices that have traded futures markets, such as the S&P 500 and Nasdaq-100.

This aspect provides a clear advantage for swap-based ETFs compared to physical ETFs, which are subject to paying dividend withholding tax on the equities that they must hold to replicate the index. Physical ETFs domiciled in certain European markets will normally have this tax rate reduced to 15% because of tax treaties, but the 0% tax deducted for swap-based ETFs can make a meaningful difference in performance, especially when compounded over the long term.

Swap-based ETFs can also gain an advantage when replicating UK and European equity indices. Since these ETFs can hold equities that aren’t in the index being tracked, they should not have to pay the Stamp Duty or Financial Transaction Tax that physically replicated ETFs are forced to pay when buying shares in the UK and certain European markets. 

Case 2: Attractive swap economics

The second broad situation when a swap-based ETF can have an advantage is when the ETF is able to negotiate favourable terms with the swap counterparties. Normally, you would expect the ETF to pay a swap fee to the counterparty, but in some instances, the counterparty may be willing to pay the swap fee to the ETF, which effectively reduces the total costs of the fund. In select cases, the net effect could result in the ETF being able to outperform the index.

One such example is in China. The A-shares equity market tends to be a profitable environment for market-neutral strategies, but securities lending and other hedging mechanisms traditionally used by these hedge funds are not available to them in this market. As a result, they often turn to banks to offset the risk. Banks provide these facilities (for a generous fee) and are willing to pay an ETF to take the market exposure through a swap agreement.

Other examples can be found when replicating certain fixed income exposures, such as in the overnight return swap market. A swap-based ETF may be able to obtain attractive terms from counterparty banks because the structure provides them a means to finance equity positions on their books, reducing the banks’ balance sheet costs. This means the banks are willing to provide compelling swap economics to the ETF, which could result in an excess return above the benchmark. This could be particularly attractive for investors looking for a liquid, higher returning alternative for cash allocations.

What about the risks?

Using swaps to replicate an index is not without risk, but measures can be put in place to reduce it. Aside from the common risks associated with any investment, the use of swaps introduces counterparty risk, i.e., that the swap counterparty is unable to fulfil its side of the contract. At Invesco, we seek to reduce this risk through:

Holding a basket of quality equities: Invesco’s swap-based ETFs hold a basket of equities that are different from those in the index being tracked. The basket is owned by the ETF (not used as collateral) and provides a store of value in the unlikely event of a counterparty default.

The use of multiple counterparties: Our swap-based ETFs can have up to six counterparties, which reduces the potential financial impact on the ETF if any one counterparty defaults. We only select counterparties with high credit ratings, regularly monitor these and stress-test potential risk scenarios.

Resetting the swaps: The value of the swap, known as the mark-to-market, is reset to zero whenever certain conditions are met, such as when there is a creation/redemption in the fund, or the mark-to-market value exceeds a strictly defined level. These frequent resets are intended to limit the amount of counterparty risk.

Why Invesco for swap-based ETFs?

We have championed the use of swap-based ETFs for more than 15 years, creating our multi-counterparty swap model in 2009. However, we are agnostic when it comes to the structure of each ETF, choosing on a case-by-case basis what replication method can produce the most favourable outcome for investors. Our market-leading swap-based platform currently has US$76 billion of assets under management in 58 funds, including the largest swap-based ETF in the world. Providing investors with highly efficient tracking for a wide range of exposures.