Exchange-traded funds (ETFs) are a cost-efficient way to access a variety of investment exposures and hence have gained much popularity among investors. To keep up with the demand for transparent, liquid, cost effective diversified investment products, new and advanced versions of ETFs have been developed over the years. With these innovations, ETFs have not only become more numerous and popular but also more complex! One such innovation is the synthetic ETF which is seen as a more exotic version of traditional ETFs.

First Things First: What is a Synthetic ETF?

Swap Costs

Management Fees

Risk & Return

Synthetic ETFs use swap contracts to enter into an agreement with one or more counterparties who promise to pay the return on the index to the fund. The returns thus depend on the counterparty being able to honor its commitment. This exposes investors in synthetic ETFs to counterparty risk. There are certain regulations which restrict the amount of counterparty risk to which a fund can be exposed. For instance, according to Europe’s UCITS rules, a fund’s exposure to counterparties may not exceed a total of 10% of the fund’s net asset value. In order to comply with such regulations, ETF portfolio managers often enter into swap agreements that ‘reset’ as soon as the counterparty exposure reaches the stated limit.

The counterparty risk can further be limited by collateralizing and even over collateralizing the swap agreements. Regulators require the counterparty to post collateral in order to mitigate the counterparty risk. In case, the counterparty defaults on its obligation, the ETF provider will have a claim to the collateral, and thus the investors’ interest is not hurt. The investors are more protected from losses in the event of a counterparty default when there is a higher level of collateralization and more frequency of swap resets.

Though measures are taken to limit the counterparty risk (it’s more than in physical ETFs), investors should be compensated for being exposed to it for the attractiveness of such funds to remain intact! The compensation comes in the form of lower costs and lower tracking errors.

Synthetic ETFs are particularly very effective at tracking their respective underlying indices and usually have lower tracking errors especially in comparison to the physical funds. The total expense ratio (TER) is also much lower in the case of synthetic ETFs (some ETFs have claimed 0% TERs). Compared to a synthetic ETF, a physical ETF incurs larger transactional costs because of portfolio rebalancing and tracking errors between the ETF and benchmarks.

The Bottom Line

Synthetic ETFs can act as a gateway for investors to gain exposure in markets that are hard to access (namely, obscure or less liquid markets). They also come in handy for investors when it’s impossible or expensive to buy, hold and sell the underlying investment in some other way. However, the fact that such ETFs involve counterparty risk cannot be ignored, and thus the reward has to be high enough to mitigate the risks undertaken. For investors who understand the risks involved, a synthetic ETF can be a very effective, cost efficient, index tracking tool.

More From Investopedia