Why synthetic ETFs have the edge in US-dominated markets

• Level: For advanced
• Reading duration: 5 minutes

Line up the S&P 500 ETFs from the world’s leading providers and compare them over the longest time frame you can. You’ll notice that three ETFs have pulled ahead of the pack: The top three have a significant edge over the rest. A persistent return advantage that adds up over time. The market-leaders’ secret sauce is that they’re all synthetic ETFs. The trailing pack, by contrast, uses physical replication to generate the S&P 500’s return.

Why synthetic ETFs boss physical ETFs in the US

Synthetic ETFs have the whip hand because they don’t pay withholding tax in the US. Withholding tax is typically levied on income earned by foreign owners of assets and corporations domiciled within a country. The main rate of US withholding tax is 30 %. So you can expect dividends and interest paid by US securities to arrive in your bank account after taking a 30 % tax haircut. (The same is true even if you reinvest your dividends in an accumulating ETF.) However, you can reduce US withholding tax to 15 %, and even 0 %, by choosing the right ETF. For example, Irish domiciled ETFs enjoy a 50 % US withholding tax rebate. Thus, Irish-based physical ETFs pass on US income minus 15 % tax. Luxembourg is the other major jurisdiction for ETFs sold in Europe. However, Luxembourg’s US tax treaty does not reduce the 30 % withholding tax rate. Hence, physical S&P 500 ETFs are headquartered in Ireland not Luxembourg.

Synthetic ETFs go one better

Synthetic S&P 500 ETFs aren’t compelled to hold US securities. For that reason, they’re able to radically cut and even eliminate their US withholding tax bill. You can see this in the annualised performance figures delivered by synthetic ETFs. The third-placed synthetic ETF earned an average annual return 0.12 % higher than the best-placed physical ETF in our comparison above. Meanwhile, the gap is a tasty 0.26 % per year when we compare the top-ranking synthetic ETF with the lowest placed physical product in the chart. Annual performance differentials in that range are well worth snapping up especially as the gain is persistent so long as the tax advantage exists. One way to look at it is that the tax rebate pays your ETF fees for you.

Tax-bomb shelter

Synthetic ETFs were first launched in Europe back in 2001. They’re not new. Moreover, US legislation exempts swaps from withholding tax when they relate to specific stock market indices, including the S&P 500 and the MSCI World. In other words, you needn’t fear that synthetic ETFs are some elaborate tax avoidance scheme. This feature means that synthetic ETFs are a plausible way to shelter your assets from US withholding taxes, plus any forthcoming rises. The Trump administration recently flirted with such a move in its signature “One Big Beautiful Bill” legislation. This tax and spend act included a proposal for increasing the withholding tax rate up to 50 % on the residents of EU countries and the UK. The proposal was widely interpreted as a retaliatory measure aimed at non-US countries, targeting the undertaxed profits of American multinational corporations. The danger has been averted for now, as the “Section 899” provision was dropped from the legislation following an agreement reached by the US with its G7 trading partners. Intriguingly, the One Big Beautiful Bill Act did not simultaneously attempt to remove the withholding tax exemption enjoyed by synthetic ETFs. So synthetics remain a useful tool should the Trump administration decide to scrap the G7 deal, or revisit withholding taxes to gain economic leverage in the future.

Do World synthetic ETFs have edge?

US firms now comprise around 71 % of the MSCI World index. Intuitively, you’d expect swap-based ETFs to nose ahead in this market too, due to their withholding tax trump card. In this case, only one of three synthetic MSCI World ETFs beats their physical rivals over the longest comparable timeframe. Moreover, the Amundi ETF’s lead is only 0.01 % per year on average versus the best of the physical ETFs. That’s not worth worrying about. However, this result may also underplay the opportunity. Costs are the confounding factor in the World market. For example, the Xtrackers MSCI World Swap has a TER of 0.45 %. Whereas the most competitive category ETFs boast TERs as low as 0.06 %. That cost disparity can easily overwhelm the synthetic product’s withholding tax advantage.

How to calculate the withholding tax advantage

You can work out the approximate annual withholding tax liability of a physical ETF like this: ETF 12-month dividend yield x US asset allocation x Withholding tax rate for the ETF’s domicile. At the time of writing, the numbers for Irish-domiciled, physical MSCI World ETFs are approximately: 1.28 % x 71.5 % x 15 % = 0.14 % loss due to US withholding tax Assume a rival synthetic ETF loses 0 % to US withholding tax. Hence, if the synthetic ETF is 0.14 % more expensive than its physical rivals, then you wouldn’t expect it to routinely win based on its withholding tax advantage. Search for low-cost synthetic ETFs. The solution is to look for the more competitively priced World swap ETFs that have hit the market over the past few years. You can find them on justETF’s ETF Screener by selecting:

1. Equity
2. Region > World
3. Replication method > Swap-based

Then rank the selection by TER. Compare your synthetic selection against their most cost-competitive physical competitors. Choose the longest time frame you can for the most reliable match-ups. The shorter the time frame, the less likely you are to find a signal amid the noise. Even then, it’s still possible for physical ETFs to outperform synthetics in US-dominated markets. You’ll notice this happens with Nasdaq 100 ETFs. Take into account the following factors:

• Cheapest TER
• Check your ETF’s fact sheet to see if the swap fee is included in the product’s TER. (Some synthetic ETF providers don’t do this, which flatters the TER.)
• Check the ETF’s securities lending return. This improves performance but adds risk.
• Is the index the same? Different indices can outperform from year-to-year. For example, the FTSE Developed World may beat the MSCI World from time-to-time.
• The total return swap’s withholding tax exemption does not apply to every index.
• Dividend yield: The lower the yield, the less withholding tax matters.
• US asset allocation: The higher the allocation to US securities, the more withholding tax matters.
• ETF domicile: The US withholding tax rate varies from country to country.

If you prefer a truly global approach incorporating emerging markets, then look out for synthetic MSCI All Country World Index (ACWI) ETFs. The withholding tax advantage is real, but it’s most pronounced among S&P 500 ETFs. Happy hunting!