A synthetic ETF is an asset designed to replicate the performance of an underlying index using derivatives and swaps rather than physical securities. Providers enter an agreement with a counterparty – usually an investment bank – that ensures future cash flows gained by the underlying benchmark are returned to the investor. In other words, the synthetic fund tracks the index without owning any physical securities.

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

Breaking Down Synthetic ETF

Synthetic ETFs are common in European and Asian markets, where exchanges place an X in front of the names to differentiate them from a traditional fund. The country's financial regulators, concerned about whether investors are financially sophisticated enough to understand the different characteristics and risk profiles of synthetic ETFs, have subjected synthetic ETFs to greater scrutiny and imposed additional 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 for the rights to the gains generated by the benchmark index. The funded swap model operates similarly, but the collateral basket is placed into a separate account rather than the ETF.

More importantly, the collateral posted by the ETF swap counterpart does not have to track the benchmark index. Even the asset classes included in the collateral can differ from the benchmark, but they are often highly correlated. 

Pros and Cons of Synthetic ETFs

Proponents of synthetic funds claim 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 conflicts of interest. In many cases, it's uncertain if both parties will live up to their side of the obligation. Using collateral can help mitigate risks tied to default and the other parties.