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.