Synthetic ETF

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A synthetic ETF is an investment that mimics the behavior of an exchange-traded fund (ETF) through the use of derivatives such as swaps.[1]

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.[note 1] They are the dominant form of ETF ̧ especially in the US and are mainly provided by large independent asset managers.[2]

Synthetic ETFs allow replication of the index using derivatives as opposed to owning the physical assets.[3]

One popular synthetic structure involves the use of total return swaps,[note 2] which the ETF sponsors refer to as the unfunded swap structure (Figure 2). 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.[3]

(insert Figure 2)

Types of Risks

  • Counterparty risk
  • Collateral risk
  • Liquidity risk
  • Conflicts of interest

Notes

  1. To limit transaction costs due to the rebalancing of index components, physical ETFs generally hold a sample of the securities composing the index rather than the full basket. The resulting basis risks related to the physical ETFs’ index tracking quality are generally managed from the revenues that the ETF derives from securities lending.
  2. A total return swap is a bilateral financial transaction where the counterparties swap the total return of a single asset or basket of assets for periodic cash flows, typically a floating rate such as Libor.

See also

References

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