Updated on March 11, 2023
Synthetic ETFs are ETFs which are considered to be the opposite of physical or normal ETFs. In a physical ETF, a basket of shares are bought which mimic the index being tracked by the ETF. Synthetic ETFs, on the other hand, do not hold or buy securities but enter a total return swap agreement with financial institutions, like banks, which promise to pay the return on the benchmark to the ETF. These are quite popular in the European markets and to some extent in US markets and are more risky than the traditional ETFs.
Types of Synthetic ETFs
Synthetic ETFs come in two formats – Unfunded and Funded.
Under this swap model, the ETF issuer creates new shares in exchange for cash from the authorized participant and enters into a total return swap with a counterparty. The ETF issuer uses the investors’ cash to buy securities from the swap counterparty, which promises to deliver the return of the benchmark index. In exchange, the swap counterparty receives the return generated by the substitute basket. The assets here are owned by the ETF issuer in the substitute basket, who can liquidate them if the swap counterparty defaults.
In this swap model, the issuer transfers the cash received from investors to a swap counterparty and the collateral basket is placed into a segregated account with an independent custodian and is not owned by the ETF.