Swaps can be more tax friendly for dividends
With mega cap tech MAG7 names making up roughly one third of the S&P 500 - and over 40% of the Nasdaq 100 even after its rebalancing exercise capped their weights - investors who want more diversification by industry groups and individual companies may be attracted to an equal weighted index. Over the past few months, the US equity bull market has started to broaden out beyond mega cap tech names, and in the first 20 days of January, an equal weighted S&P 500 tracker such as RSP has outperformed SPY by about 1%.
These products are seeking to replicate the same index returns before fees: S&P 500 Equal Weight Index. At quarterly rebalancing dates all 500 names should be around 0.20% but in the interim they can grow bigger or smaller. At the time of writing the largest holding is Constellation Energy at 0.25%, which is clearly much smaller than the largest names in the cap-weighted S&P 500 index where Apple, Nvidia and Microsoft all exceed 6%.
RSP is Invesco’s physically replicated equal weight S&P 500 tracker and iShares S&P 500 Equal Weight UCITS ETF (ISPE) also uses physical replication. Invesco charges 0.20% and iShares 0.22%.
Invesco has now just launched S&P 500 Equal Weight Swap UCITS ETF (SPWS), which is said to be the first synthetically replicated equal weight S&P 500 ETF and charges the same fee as RSP.
Synthetic ETFs pay less tax on dividends thanks to the 2017 HIRE Act: the total return of an index used for a swap need to pay withholding tax on dividends. ETFs based on physical replication could pay 15% tax on US dividends where domiciled in Ireland and 30% where domiciled in Luxembourg. (This is quite separate from the potential capital gains tax advantages US based investors get from ETFs compared with mutual funds).
Tax transparency rules and the intricacies of various double tax treaties in some countries could add more complication, but in many cases the tax-free dividends could well enhance returns for longer term holders - and add between 0.20% and 0.40% to the current dividend yield, relative to the two examples above. Since US equities have a relatively low dividend yield, currently forecast at 1.25%, because companies return a lot of capital through buy backs, the dividend withholding tax issue is actually less important than in other countries - but is nonetheless an important factor for long term investors.
Investors using ETFs for shorter term and even intraday trading strategies may be more interested in comparing liquidity