What is a Synthetic ETF?

A synthetic ETF is an exchange-traded fund (ETF) that uses derivatives, such as swaps, rather than holding the actual underlying assets to track an index or asset class. Instead of physically buying stocks, bonds, or commodities, a synthetic ETF enters into swap agreements with a financial institution to replicate the performance of the target index.

Synthetic ETFs are widely used in markets where buying the underlying assets is difficult, expensive, or inefficient, such as emerging markets, commodities, and leveraged strategies.

How a Synthetic ETF Works

A synthetic ETF achieves index replication through a total return swap agreement with a counterparty (usually an investment bank). The process works as follows:

1. The ETF provider deposits cash or a collateral portfolio with a swap counterparty.
2. The swap counterparty agrees to deliver the return of the target index.
3. In exchange, the ETF provider pays a small fee for the swap agreement.
4. The ETF’s net asset value (NAV) tracks the index based on the swap’s performance.

For example, a synthetic ETF tracking the S&P 500 does not hold all 500 stocks. Instead, it enters a swap agreement where a bank delivers the index return without directly buying the stocks.

Types of Synthetic ETFs

1. Fully Funded Swap ETF

• The ETF provider transfers all assets to the counterparty in exchange for index returns.
• Used in markets where physical replication is impractical.

2. Unfunded Swap ETF

• The ETF holds a collateral basket of assets, reducing counterparty risk.
• The swap counterparty provides the index return in exchange for a small fee.

Synthetic ETFs vs. Physical ETFs

Feature	Synthetic ETF	Physical ETF
Replication Method	Derivative-based (swaps)	Direct asset ownership
Liquidity	High	Depends on market access
Counterparty Risk	Yes	No
Tracking Error	Low	Higher due to transaction costs
Best Use Case	Hard-to-access markets	Traditional indices

Advantages of Synthetic ETFs

• Lower Costs – Reduced transaction costs compared to buying hundreds of individual stocks.
• Efficient Market Access – Provides exposure to hard-to-trade assets (e.g., commodities, emerging markets).
• Reduced Tracking Error – Swaps deliver precise index replication.
• Tax Efficiency – In some jurisdictions, synthetic ETFs offer better tax treatment.

Risks of Synthetic ETFs

• Counterparty Risk – If the swap provider defaults, ETF investors may lose money.
• Regulatory Risks – Some markets impose restrictions on derivative-based ETFs.
• Complexity – Synthetic ETFs involve structured financial agreements, making them less transparent.

FAQs

What is a synthetic ETF?

A synthetic ETF is an exchange-traded fund that uses derivatives (swaps) instead of directly holding assets to replicate an index.

How does a synthetic ETF differ from a physical ETF?

A synthetic ETF relies on swap agreements with a counterparty, while a physical ETF owns the underlying assets.

Are synthetic ETFs riskier than physical ETFs?

Yes, synthetic ETFs carry counterparty risk since they depend on the swap provider’s ability to meet obligations.

Why do investors use synthetic ETFs?

They offer cost-effective access to hard-to-trade markets, lower tracking errors, and tax advantages in some cases.

What happens if the swap counterparty defaults?

Investors may face losses, but collateral arrangements often reduce the risk.

Do synthetic ETFs pay dividends?

Yes, synthetic ETFs can distribute dividends, but payments are derived from the swap structure.

Are synthetic ETFs regulated?

Yes, financial authorities impose rules to limit counterparty risk and improve transparency.

Can synthetic ETFs be leveraged?

Yes, leveraged synthetic ETFs use swaps to amplify returns (e.g., 2x or 3x the index performance).

How do I know if an ETF is synthetic?

ETF providers disclose replication methods in fund fact sheets and prospectuses.

Are synthetic ETFs suitable for long-term investing?

They can be used for long-term exposure, but counterparty risks and regulatory changes should be considered.