What are Synthetic ETFs?

Like standard exchange traded funds, the goal of synthetic ETFs is to track and mirror an index or benchmark performance. So what's the difference? While standard ETFs usually invest in all the securities in the index or a sample of the securities, synthetic ETFs enters into a swap agreement with a counterparty in order to match the index performance.

How does Synthetic ETFs Work?

The ETF fund enters into a swap agreement with a counterparty, with the percentage of exposure determined by the Australian Securities Exchange (ASX). This percentage is no more than 10 percent of the ETF's net asset value (NAV).

Why is a swap used? Because there is a difference between ETF returns and the underlying index. It's normal to see tracking errors occur; a swap ensures that tracking errors are reduced.

Swap Agreement

Under the swap agreement, there are two possible scenarios. If the portfolio underperforms the index, the counterparty must make a payment to the fund. If the portfolio outperforms the index, the fund must pay the counterparty.

The overall effect is that portfolio returns and payments to and from the counterparty replicates index performance.

Synthetic ETF Risks

On top of the risks associated with standard ETFs, synthetic ETFs carry the risk that the counterparty will not fulfill its obligations and pay up. In the event that the counterparty defaults, your ETF will drop in value. Two things happen: the NAV will be reduced by the amount owed by the counterparty and the ETF, along with your capital, will have access to the physical assets kept by the custodian.

So how does the investor hedge against these risks? The ASX has regulations in place to minimise risk associated with this investment. As mentioned, counterparties can incur debt from the ETF no more than 10 percent of the NAV. The ASX immediately takes action to reduce exposure if this limit is exceeded.

The ASX also filters the counterparties that ETF issuers can have contracts with; Australian banks and authorised foreign banks are eligible.