Synthetic ETFs

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

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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. 

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So how do ETFs use these types of investments?

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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. 

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

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

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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. 

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

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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.  

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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. 

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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. 

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