What it means
A traditional ETF, known as a physical ETF, buys the securities in the index it follows. A synthetic ETF takes a different route: it holds a basket of assets and signs a swap with a counterparty, usually an investment bank, under which the bank pays the fund the return of the index in exchange for the return on the basket.
The investor gets the index return without the fund owning the index's shares. There are good reasons to do this.
Some markets are hard to access directly, because of restrictions, high costs or poor trading conditions in commodities and emerging markets. A swap can deliver the return without these frictions, and it can also reduce the tracking error, which is the gap between the fund's return and the index's return.
The main risk is counterparty risk. If the bank that provides the swap cannot pay, the fund may suffer a loss, even though the index has performed well.
To control this, funds hold collateral from the bank, and in some regions regulators limit the share of the fund's value that can be exposed to a single counterparty. Investors should look at what the fund holds as collateral, how often it is topped up, and how the swap is priced.
Transparency varies, and some providers publish daily details of their baskets and swap exposure. A synthetic ETF can also be more complex to explain, so it is worth reading the factsheet before buying.
Costs matter too. Synthetic ETFs often have low stated fees, but the swap price and the performance of the collateral basket can add or subtract from returns.
Comparing the fund's returns with its index over a year, rather than just its fee, gives a truer picture.
In practice
Real-world examples.
Example
An investor in Europe wants exposure to an index of US shares with a large part of its value in dividends that attract withholding tax. A synthetic ETF may deliver the return more efficiently, and she compares its tracking record with physical alternatives.
Example
A fund manager wants exposure to a commodity index without holding physical goods. A synthetic ETF gives it the price return through a swap, and the manager checks the credit quality of the bank providing the swap.
Example
A financial adviser building a portfolio for a small business owner avoids synthetic ETFs for the core holdings. She prefers a physical fund for the main equity exposure, because she wants to remove the extra layer of counterparty risk for the client.
Formula
Calculation
Tracking difference = ETF return - Index return
Suppose an index returns 8.0% over a year and a synthetic ETF tracking it returns 7.6%.
Tracking difference = 7.6% - 8.0% = -0.4%
On a $50,000 investment, the shortfall is $50,000 x 0.004 = $200 a year.
If a physical ETF on the same index returned 7.3% because of trading costs and withholding taxes, its tracking difference would be 7.3% - 8.0% = -0.7%, or $350 a year, so the synthetic fund would have tracked more closely in this example.
The saving of $350 - $200 = $150 a year must be weighed against the counterparty risk.Case study
Seen in the real world.
Greystone Asset Management is an illustrative, fictional firm that offers a synthetic ETF tracking an emerging market index. The market has restrictions on foreign investors, and holding the shares directly would be costly and slow.
The fund enters a swap with a large bank, and the bank posts collateral worth at least 100% of the swap's value, topped up daily. If the bank defaulted, the fund could sell the collateral to cover the amount it was owed.
In the illustrative first year the fund returned 9.2% against an index return of 9.4%, a tracking difference of -0.2%. The firm publishes the counterparty and collateral details every day, which investors cited as a reason they were comfortable holding the product.
Watch out
Common mistakes.
- Assuming a synthetic ETF owns the shares in the index, when it holds a swap and a different basket of assets.
- Ignoring counterparty risk because the ETF is listed on an exchange.
- Comparing funds only by headline fee, when tracking difference shows what investors actually received.
Questions
People also ask.
What is the main risk of a synthetic ETF?
The risk that the swap counterparty fails to pay, which collateral and regulatory limits are designed to reduce.
Why do providers use swaps?
To get exposure to markets that are costly or hard to reach, and to reduce tracking error and trading costs.
How can I check how safe a synthetic ETF is?
Look at the factsheet for the counterparty, the level and quality of collateral, and how often it is topped up.
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