Synthetic ETFs

An ETF that that reproduces the return of an index through the use of swaps.

A synthetic ETF is an exchange traded fund that reproduces the return of an index through the use of swaps. 

A swap is a contract between two parties where one party wants to receive the return of a collection of assets or a benchmark and the other party wants to earn a fee plus the return of some other asset or benchmark. 

So how do ETFs use these types of investments?

An ETF is a type of investment fund, listed on a stock exchange, that typically tracks the performance of an index. The index could represent the returns of a basket of stocks, bonds, commodities or other assets. 

An ETF can reproduce the returns of the index it’s meant to track either “physically”, by buying the underlying assets, or “synthetically”. 

With a synthetic ETF, instead of directly buying the assets, the ETF will enter into swap agreements with financial institutions, called “counterparties”. 

In the swap agreement the bank agrees to pay the ETF the return of the index it’s tracking. The ETF pays the bank a fee and the returns of a basket of securities it holds as collateral. 

There are two models of swaps that ETFs use: funded and unfunded swaps. 

In an unfunded swap, the ETF provides assets that it owns, such as shares in other companies, as collateral. In a funded swap, the ETF sends cash to the investment bank to invest directly in the assets.  

Synthetic ETFs can be beneficial because they may offer tax benefits or provide access to a market that is otherwise tricky for retail investors to access. 

However it’s also important to note that this type of ETF also adds counterparty risk - the risk that the bank that works with the ETF defaults - to the risks associated with the investment. 

That means that certain securities that use this type of replication method may be considered more complex than an ETF that uses physical replication. 

More terms

Investment Return
Read More
Rate of Return
Read More
Packaged Retail and Insurance-based Investment Product (PRIIP)
Read More
Custodian bank
Read More
Junk Bond
Read More
Venture Capital Trust (VCT)
Read More
American Depository Receipt (ADRs)
Read More
Annualised Rate of Return
Read More
Pick the plan that suits you best
Save 17% when you choose an annual subscription.
Basic
£0.00
/Month
Accounts
  • General Investment Account
Benefits
  • A great way to try Freetrade before transferring your ISA or pension
  • Unlimited commission-free trades. Other charges may apply.
  • Trade USD and EUR stocks at the exchange rate + 0.99% FX fee
  • Access to a selection of Freetrade’s 6,200+ global stocks and ETFs
  • 1% AER on up to £1,000 uninvested cash
  • Fractional US shares
  • Access to mobile app and web platform
Standard
£4.99
/Month
£59.88 billed annually
Accounts
  • General Investment Account
  • Stocks and shares ISA
Everything in Basic and:
  • Access to 6,200+ stocks and ETFs
  • A lower FX fee of 0.59% on non-GBP trades
  • 3% AER on up to £2,000 uninvested cash
  • Automated order types, including recurring orders
  • More stats and analysis, including analyst ratings and EPS estimates 
Plus
£9.99
/Month
£119.88 billed annually
Accounts
  • General Investment Account
  • Stocks and shares ISA
  • Personal pension
Everything in Standard and:
  • A lower FX fee of 0.39% on non-GBP trades
  • Priority customer service
  • 5% AER on up to £3,000 uninvested cash
Basic
£0.00
/Month
Accounts
  • General Investment Account
Benefits
  • A great way to try Freetrade before transferring your ISA or pension
  • Unlimited commission-free trades. Other charges may apply.
  • Trade USD and EUR stocks at the exchange rate + 0.99% FX fee
  • Access to a selection of Freetrade’s 6,200+ global stocks and ETFs
  • 1% AER on up to £1,000 uninvested cash
  • Fractional US shares
  • Access to mobile app and web platform
Standard
£5.99
/Month
billed monthly
Accounts
  • General Investment Account
  • Stocks and shares ISA
Everything in Basic and:
  • Access to 6,200+ stocks and ETFs
  • A lower FX fee of 0.59% on non-GBP trades
  • 3% AER on up to £2,000 uninvested cash
  • Automated order types, including recurring orders
  • More stats and analysis, including analyst ratings and EPS estimates 
Plus
£11.99
/Month
billed monthly
Accounts
  • General Investment Account
  • Stocks and shares ISA
  • Personal pension
Everything in Standard and:
  • A lower FX fee of 0.39% on non-GBP trades
  • Priority customer service
  • 5% AER on up to £3,000 uninvested cash

You’re just minutes away from commission-free investing

When you invest, your capital is at risk