Synthetic ETFs replicates benchmark index without acquiring any underlying security of an index, it uses derivative contracts such as swaps to track the benchmark index.
Synthetic Method of constructing ETF is mainly practiced in Europe. It has been observed that the synthetically replicated ETFs track the index more efficiently and accurately than Physical ETF.
In Synthetic Replication, ETF provider enters into a swap agreement with a counterparty mostly investment bank. In this swap contract, investment bank agrees to pay the Index Return in exchange for a fee and any returns on collateral held in the ETF Portfolio.
Synthetic ETF Function
Based on the type of holding collateral, synthetic replication is classified in two structures :
Funded Swap Structure
Un-Funded Swap Structure
In Funded Swap Structure, the ETF Fund transfers the cash or collateral basket to the counterparty, then the counterparty transfer it to an independent custodian, who holds it on behalf of ETF Fund. In return of cash or collateral basket, the counterparty delivers the returns of the target index to ETF Fund.
In Un-Funded Swap Structure, the ETF Fund enters into a swap agreement with the counterparty, which states that ETF will proceed all the necessary actions from the sale of units, to purchase and hold of collateral. Then the returns generated by collateral basket transferred to the counterparty in exchange for index returns.
Under UCITS regulations, Synthetic ETF set up have to comply with UCITS rules relating to eligibility of assets and use of derivatives. Therefore Synthetic ETFs often attempt to minimize the risk through multiple counterparties and limits eachswap contract to maximum 10% of the fund's market value in accordance with UCITS Regulations.
ETF Issuer basically uses the Synthetic ETF in order to track the index that has little or almost zero tracking error. Also, its mechanism makes it cost efficient compared to Physical ETF. Synthetic ETF can be more beneficial when one needs access to large and illiquid indices of emerging markets.