Synthetic ETFs

RoadToRiches

I am considering investing in a synthetic ETF that tracks the US markets. Also considering the various world geographies for other ETFs to diversify. Using the US as an example as plan on holding the majority of my investment here.

The idea being to avoid Dividend Withholding Tax in the US.  Are there any risks with these type of synthetic ETFs? E.g. securities lending? Thinking Invesco Markets Plc MSCI World (MXWS) as an example. Thoughts? 

[Deleted User]

Yes.  Not familiar with the particular tool but typically there is so-called “counter-party exposure” risk.   This is a material risk to performance which you should be compensated for.  Typically, there is another institution involved which agrees a swap with your fund, and that institution may go bankrupt.  Personally, not a fan of such tools. In general, the more financial engineering, the more complex the instrument, the less you understand, the more risk you take.  

Normally there is a way to avoid dividend withholding tax without taking extra risk.  For example, I invest in US domiciled ETFs within a pension wrapper or within non-registered accounts.   Even if you are subject to withholding taxes, the “damage” is 15% of the dividend value which is typically low; of the order of 1%. So its only costing you 15 basis points. 

dunstonh

Brave of you to use synthetic ETFs. Normally, it's one of the first things to go in the filtering out of options.  Although if it's just a very small ratio of the overall portfolio then there is no harm as long as you understand the extra risks.

RoadToRiches

So best to stick with the physical ETF’s to avoid the counter party risk.

Secret2ndAccount

Bear in mind that most US companies favour buying back their own shares (thus inflating the share price) rather than paying out dividends. This is because US shareholders usually pay tax on dividends, but are more likely to be able to avoid tax on price growth.
Last year, the S&P 500 paid out 1.3% in dividends (10 year average is about 2%), so your tax bill is going to be a fraction of a %.

Most countries offer pretty good protection in law that says if you are the owner of a share (or an ETF) and the platform holding your share goes bankrupt, you maintain your beneficial interest in the share - you will eventually get your shares back. When you use a synthetic ETF, you start to break that link. If the party simulating the index goes bankrupt you could end up out of pocket because you don't own the shares involved.

[Deleted User]

RoadToRiches said:

So best to stick with the physical ETF’s to avoid the counter party risk.

Yes, if your only reason for using them is withholding taxes. You can still either entirely eliminate or at least minimize withholding taxes.   

Typically the reason to use swap ETFs is to minimize and/or defer tax on dividends in a taxable account.  And then its a judgement call.  The other risk with them is that regulations and/or tax treatment changes and the loopholes are closed while the holders end up with a large liability all at once. 

jamesd

Synthetic ETFs normally require the counterparty to deliver them security. If they go bankrupt you keep the security. That could be say Japanese government bonds for a US equity tracker.

[Deleted User]

jamesd said:

Synthetic ETFs normally require the counterparty to deliver them security. If they go bankrupt you keep the security. That could be say Japanese government bonds for a US equity tracker.

I think we are talking about swap ETFs. One institution sets up a contract with another institution (counter-party). Its never the government.  The second institution provides the equivalent value of total index return, including dividends. Investor invests in a product held by the first institution.  If the second institution goes bankrupt then the investor will experience a loss; as a minimum he will lose his dividends.  

RoadToRiches

Deleted_User said:

jamesd said:

Synthetic ETFs normally require the counterparty to deliver them security. If they go bankrupt you keep the security. That could be say Japanese government bonds for a US equity tracker.

I think we are talking about swap ETFs. One institution sets up a contract with another institution (counter-party). Its never the government.  The second institution provides the equivalent value of total index return, including dividends. Investor invests in a product held by the first institution.  If the second institution goes bankrupt then the investor will experience a loss; as a minimum he will lose his dividends.  

Yes very much like what happened in the film - The Short - if I am not mistaken where they had to get rid of their swaps before the counterparty went under..

[Deleted User]

The Big Short?  Kinda like that but they used a different type of derivatives 

jamesd

Deleted_User said:

jamesd said:

Synthetic ETFs normally require the counterparty to deliver them security. If they go bankrupt you keep the security. That could be say Japanese government bonds for a US equity tracker.

I think we are talking about swap ETFs. One institution sets up a contract with another institution (counter-party). Its never the government.  The second institution provides the equivalent value of total index return, including dividends. Investor invests in a product held by the first institution.  If the second institution goes bankrupt then the investor will experience a loss; as a minimum he will lose his dividends.  

Depends on whether the value of the security has been updated to reflect the current value of the investment and I expect that it will need to be regularly  updated to do that. Government bonds are a likely choice for security, but as you wrote, governments themselves don't get involved in this.