A synthetic ETF is an exchange-traded fund that uses financial derivatives, such as total return swaps, to track the performance of an underlying index instead of physically holding the individual securities comprising that index.
Understanding synthetic ETFs
Traditional exchange-traded funds operate by purchasing the actual stocks or bonds that make up a specific index. A synthetic ETF takes a different approach by entering into a contract with a counterparty, typically a large global investment bank. The bank agrees to pay the fund the exact return of the target index. In exchange, the fund pays the bank a fee and provides cash or other assets as collateral.
These financial instruments are useful in markets where purchasing the underlying assets directly is expensive or legally restricted. Some emerging markets impose strict foreign ownership limits on local shares. A synthetic structure allows international investors to gain exposure to these markets without navigating local regulatory barriers. They also offer lower tracking error than physical ETFs because the counterparty guarantees the exact index return.
The primary risk associated with this structure is counterparty risk. If the investment bank providing the swap defaults or goes bankrupt, the ETF could lose value. Regulatory bodies require counterparties to post collateral to offset this risk. In the European Union, the UCITS directive outlines strict collateral requirements for synthetic ETFs to protect investors.
Geographic availability varies significantly. Synthetic ETFs are common on European and Asian stock exchanges. In the United States, regulations enforced by the Securities and Exchange Commission make them rare. Elephants researching global funds must review the prospectus of any ETF to identify its specific replication method.
Example
Suppose a group of Elephants wants to invest in the hypothetical African Baobab Agricultural Index, which tracks regional agricultural firms in countries with capital controls. A physical ETF provider cannot legally buy and hold the local shares. An asset manager decides to launch the Baobab Synthetic ETF. The asset manager signs a swap agreement with a global bank, and the bank promises to deliver the daily returns of the Baobab Index to the fund. The Elephants buy shares of the ETF on the London Stock Exchange. They receive the financial returns of the regional index while the fund itself never purchases a single local agricultural stock.