Synthetic ETF

A synthetic ETF enters into a total return swap with one or more counterparties, usually large banks. The bank agrees to pay the fund the return of the index; in exchange, the fund pays the bank the return on a basket of assets the fund holds, or on cash it has handed over. That basket, often called the substitute or collateral basket, may have little to do with the index itself. Under the EU’s UCITS rules, the fund’s net exposure to any one swap counterparty is generally capped at 10% of its value, and in practice the swap is reset well before that limit is reached.

Synthetic replication can track some indices more closely and cheaply than buying the securities, particularly in markets that are hard to access, and for US shares it can reduce the withholding tax drag that a physical fund bears on dividends. The trade-off is counterparty risk: if the bank fails, the fund depends on the value and quality of its basket or collateral. The structure is also harder for an ordinary investor to follow. A synthetic ETF is not the same thing as a leveraged or inverse ETF, although those also often use swaps.