Synthetic Exchange-Traded Fund: What it is, How it Works

What Is a Synthetic Exchange-Trade Fund (ETF)?

A synthetic exchange-traded fund (ETF) is a pooled investment that invests money in derivatives and swaps rather than in physical stock shares.

That is, a conventional ETF invests in stocks with the stated goal of replicating the performance of a specific index, such as the S&P 500. The synthetic exchange-traded fund also seeks to match the performance of a benchmark index, but it does not own any physical securities. Rather, the fund managers make an agreement with a counterparty, usually an investment bank, to ensure that the benchmark return is paid to the fund.

Understanding a Synthetic Exchange-Trade Fund (ETF)

Both the ETF and the synthetic ETF are relatively new types of investments available to the individual investor. The ETF was introduced in the early 1990s and quickly became popular. They were passively-managed index funds with very low management fees, similar to mutual funds. But they could be traded throughout the day, rather than sold once a day after the close of trading.

The first synthetic ETF was introduced in Europe in around 2001. It remains a popular investment in European markets, but only a small number of asset managers in the U.S. issue synthetic ETFs. This is due to specific regulations enforced by the US Securities and Exchange Commission in 2010 that prohibit the launch of new funds by asset managers not already sponsoring a synthetic ETF.

The Federal Reserve has expressed concerns about the safety of the synthetic ETF. "Synthetic ETFs are riskier structures than physical ETFs because investors are exposed to counterparty risk," a 2017 Fed study concluded.

Types of Synthetic Exchange-Trade Funds (ETFs)

Synthetic ETFs are common in both European and Asian markets, where exchanges place an X in front of their names to differentiate them from traditional funds. There is some concern among regulators in both regions about whether investors fully understand the characteristics and risk profiles of synthetic ETFs. This has led to some additional regulatory requirements on the institutions that issue them. 

There are two main types of synthetic funds: unfunded and funded.

• In an unfunded swap model, the issuer creates new shares of an ETF in exchange for cash from the authorized participant. The provider uses the cash to buy a basket of assets from the swap counterparty in exchange for the rights to the gains generated by the benchmark index.
• The funded swap model operates in a similar fashion but the collateral basket is placed into a separate account rather than the ETF. More importantly, the collateral does not have to track the benchmark index. Even the asset classes included in the collateral can differ from the benchmark, although they are often highly correlated. 

Pros and Cons of Synthetic ETFs

Proponents of synthetic funds claim that they do a better job of tracking an index's performance. It provides a competitive offering for investors seeking access to remote reach markets, less liquid benchmarks, or other difficult to execute strategies that would be costly for traditional ETFs to operate.

Critics of synthetic funds point to several risks, including counterparty risk, collateral risk, liquidity risk, and potential conflicts of interest. 

By definition, synthetic ETFs require the involvement of two parties, both of which must live up to their side of the obligation. The use of collateral can help mitigate the risks.