Hi guys it's sasha, synthetic etfs have become incredibly popular recently and a lot of people are saying that they are better than traditional etfs, but are they well in this video i'm going to explain exactly what synthetic etfs are, how they work and how they are different To traditional etfs, then i'm going to explain why so many people like them and then after that i'll explain why i think that they are actually not worth it now. First, let me cover exactly what synthetic etfs actually are. An etf is an exchange-traded fund. It just means that it is a fund that is relatively easy to buy just like any share on the stock market.

Etfs have become incredibly popular recently as a way of buying the equivalent of index funds and other types of funds where you can go and invest in something like the s, p, 500 or the total market, with very low fees and relative ease. Now, if you invest in something like vu or vusa, the vanguard s, p, 500 dtf, for example, that fund will invest in about 500 of the largest companies in the united states. On your behalf, so you actually own a tiny share of each of those companies. In total, so as the value of those individual companies grows, so does your investment and when those companies pay a dividend, you get that dividend paid to you too.

Now synthetic etf does almost exactly the same thing, but there is one big difference: the fund doesn't actually buy any of the underlying assets. These are relatively new. They've only really existed for about 20 years, so these synthetic funds do not own any of the companies in their list or index. Instead, they do deals with other investing companies through derivative products like swaps, and what this really means in plain english, is that the other company, the counterparty, will do the investing instead and they basically just pay out the effective gains over to your etf provider instead.

So what is the point? These synthetic etfs used to be more expensive because the third party has to charge fees for the service that they provide, so the annual fees on these used to be more expensive, but recently, even that has changed now. These synthetic etfs can be bought for pretty much exactly the same price and in some cases they can be even slightly cheaper than their physical replication counterparts. But what is the point? Well, why would anyone invest their money in a synthetic etf? Well, there is one big trick: a synthetic etf can help you reduce tax that you have to pay on your investments in countries like the uk and many others around the world. Taxes on dividends are higher than on capital gains.

This isn't the case in the united states, but when you invest in synthetic etfs, the beauty is that you do not ever receive any of the actual dividends. You essentially convert your dividends to become capital gains, because all of your growth you're getting from the fund is capital gains and you're going to be taxed on it as capital gains as a result, but not only that if you live outside the united states, you have To pay something called a dividend withholding tax, so if you invest in u.s companies, the us government will withhold 30 percent of all the dividends that those companies pay out to you. So some countries like the uk can have a special agreement with the united states that reduces the withholding tax to 15, but it still sits there and you're still gon na have to pay that money over before you actually receive the dividend. But if you invest in the synthetic etf you don't pay any withholding tax at all because you never receive the actual dividends.

So all of this sounds like synthetic etfs are a no-brainer. You save tax and you actually earn more by investing into this type of index. Instead of a traditional replicating df, so why wouldn't you do it well? Here is where we begin talking about risk, because that's the one thing that people often really miss out when they're talking about synthetic etfs, sure any investment has a risk. In fact, all of them have multiple different kinds of risks.

Your regular physical etf has risks too, if the market crashes so does your investment, but if the market crashes and your investment owned so many shares of each of the companies in the market, you still get to own that same number of shares of each of those Companies and you can wait for the market to grow back to grow your investment back and you can benefit from that growth, but with a synthetic etf you do not own any shares of any companies, and this is really important. You are reliant on the derivative deals that the etf provider has struck with those third parties. The counterparty risks sort of exist with physical etfs as well, because you're, entrusting vanguard or eyeshares or whoever you've got your etf with to do their bid and to actually buy the shares that you think they should be buying. But that activity is so hugely regulated and there's so much oversight on this, but we're talking almost negligible level of counterparty risk there.

So how big is the counterparty risk with synthetic etfs? Surely these big financial institutions are so robust and make so much money that you should have no risk whatsoever? You never hear about them collapsing right. So what is the issue? Well, here is the math. If you are based in the uk like me, you lose 15 percent of the dividends you receive from u.s companies. Let's take the simple example of an s: p, 500 etf and let's assume that the fees for a synthetic etf and then regular replicating one are identical, which they pretty much are at the moment.

The s p 500 dividend yield at the moment is just 1.37, but historically it's been higher. So let's use 1.8 to come up with some kind of reasonable average, so that 15 dividend withholding tax will cost you 0.27 per year on your investment. Now, in the long run, the s p 500 delivers an average return of just over nine percent of their about and over the last 15 years. That average is over 10 percent, but a lot of that is down to the recent bull run, so the amount you lose is not a huge proportion of that total.

But now, let's imagine that the counterparty to the derivative collapses and your investments go to zero. As a result, you would lose a hundred percent of your investment in that case and if you divide one hundred percent by not point two seven percent, then that means that mathematically synthetic etfs only outperform replicating ones. If this only happens once every 370 years or less often, if the counterparty the collapses is only responsible for a quarter of the total deals with that particular etf, we're still talking close to 100 years. For that break-even point, and the fact is that, although these sorts of things are very rare, they do happen, remember lehman brothers in 2008.

Well, they were an investment bank that dealt in swaps and people who held swaps with them lost a lot of money. Now importantly, there are some safety measures that do exist that i have to mention, because some people will otherwise point it out in the comments. Typically, with these types of return swaps, the counterparty will put up some kind of a collateral for a portion of the etf or their share of the etf. This can be as much as about 70 to 90 percent of the total amount of the swap.

In some cases it could be even greater than that, but although this looks good on paper in reality, it's not as rosy the collateral can come in the form of paper that becomes illiquid in the case of a financial crash, which is usually when these sorts of Things happen when things collapse and that collateral can also easily become worthless during the same crash, even if it is liquid, which would mean that it doesn't cover 90 of the etf, but maybe only covers 10 or even 0 of the amount owed even worse. The swaps that they have are fixed in time and are relatively inflexible, whereas actual physical shares can be traded on the stock market every single day. So if there was a big financial crash or some other weird unusual financial scenario, where people began withdrawing money from the synthetic etf, if that withdrawal volume was too high, the run on etf could actually collapse it because they don't have the underlying assets. So they can convert into cash to pay the money out, and here is another bit of bad news to make it even worse often, the counterparty is actually the same as the etf provider, one of the most popular providers of the etfs that are available in uk.

For example is licksaw and they use society general as the counterparty and guess what lexor is wholly owned by society general too. So that means that your risk is really not as separated as you think so. Here's my take sure you can go and get a small extra return by investing in a synthetic etf. But when you're doing it you're adding a lot of extra risk which for me is just too high and not only that.

But here's the really important bit. How about would you feel if you only earned 10.08 on average over the last 15 years instead of earning 10.35 have a thing now, i think: how bad would you feel if your entire investment collapsed all the way down to zero, now sure the risk of that Happening is low, but this is where you need to make a choice on what's more important for you and how you manage your risk. This is why i personally don't invest in synthetic etfs. I hope you found this useful if you have don't forget to smash the like button for the youtube algorithm.

Thank you so much for watching. I really really appreciate it and, as always i'll see you guys later, you.