A synthetic ETF is simply a synthetic security that trades as an ETF. It would usually replicate the returns on a portfolio, typically on an index.
A synthetic tracker can be created using swap. The swap exchanges the returns on some other portfolio of securities in return for the returns on the index being tracked. The ETF buys some other portfolio, and swaps the returns on this for the returns on the portfolio it is replicating the returns on (e.g. an index).
This arrangement tends to reduce the cost of the tracker, but does create counterparty risk. The ETF typically swaps with a bank, but it is very often the same bank (albeit usually another subsidiary) as the manager of the ETF, which can create conflicts of interest. It may be an opportunity for the bank to rid itself of an unwanted portfolio of illiquid securities.
.If the returns the ETF is entitled to from the swap exceed the returns on the portfolio swapped, then the returns depend on the counterparty meeting its obligations. This exposes the his is ETF to a default risk of the amount of the difference in returns. This is usually limited by two things:
- The counterparty is usually a bank
- Most funds limit exposure to any single counterparty
The limit on exposure to a single counterparty is required by some regulators, including the EU.
The portfolio swapped is provided by the bank to the ETF as collateral for its obligation to pay the agreed return. The level of collateral is clearly also important in assessing the risk, as are the intervals at which the return is paid, and the financial strength of the bank. If the exposure is heavy look at the collateral: both its composition (to check how liquid and volatile it is) and its value.