Synthetic ETF

A synthetic ETF is an investment that mimics the behavior of an exchange-traded fund (ETF) through the use of derivatives such as swaps.

ETF structures
There are broadly speaking two main structures for ETFs. Physical ETFs are "plain-vanilla" products that replicate the index by simply reconstituting the basket of physical securities underlying the index (e.g. the basket of S&P 500 stocks) with appropriate weight. They are the dominant form of ETF, especially in the US, and are mainly provided by large independent asset managers.

Synthetic ETFs allow replication of the index using derivatives as opposed to owning the physical assets.

One popular synthetic structure involves the use of total return swaps, which the ETF sponsors refer to as the unfunded swap structure. Under the synthetic replication scheme, the authorised participant receives the creation units from the ETF sponsor against cash rather than a basket of the index securities as in the physical replication scheme. The ETF sponsor separately enters into a total return swap with a financial intermediary, often its parent bank, to receive the total return of the ETF index for a given nominal exposure. This constitutes the first leg of the swap. Cash is then transferred to the swap counterparty equal to the notional exposure. In return, the swap counterparty transfers a basket of collateral assets to the ETF sponsor. The assets in the collateral basket could be completely different from those in the benchmark index that the ETF tries to replicate. The total return on this collateral basket is then transferred to the swap counterparty, which constitutes the second leg of the total return swap.

Types of risk
Synthetic ETFs have the following additional risks:
 * Counterparty risk
 * Collateral risk
 * Liquidity risk
 * Conflicts of interest

Forum discussions

 * ETFs that lend out their underlying securities. (link to post)

Blogs

 * A Game-Changer, from IndexUniverse
 * Synthetic ETFs could pose a threat to global financial stability, say regulators, from Monevator
 * How a synthetic ETF works, from Monevator

Periodicals

 * The rise of synthetic ETFs, from Financial Times, subscription required. (UK)
 * Now the IMF is warning about ETFs, from Financial Times, subscription required. (UK)
 * Too much of a good thing: The risks created by complicating a simple idea, from The Economist
 * Regulators Consider Ban On Retail Purchases Of Synthetic ETFs, from ETF.com - Europe
 * Regulators Consider Ban On Retail Purchases Of Synthetic ETFs - Features, from ETF.com - Europe