Synthetic ETF

A synthetic ETF is an exchange-traded fund that replicates the performance of its benchmark index not by physically holding the underlying securities, but by using derivatives — primarily total return swaps with a counterparty such as an investment bank — to replicate index returns. The ETF holds a substitute basket of collateral (which may differ from the index constituents) and enters into a swap agreement where the counterparty agrees to deliver the exact index return in exchange for the collateral's return plus a fee. Synthetic ETFs are particularly useful for gaining exposure to indices or asset classes that are difficult or expensive to replicate physically — such as commodity indices, foreign market indices, or inverse and leveraged strategies. The primary risk of synthetic ETFs is counterparty risk — the risk that the swap counterparty defaults. In India, most ETFs are physical replication funds; synthetic ETFs are less common but are used for certain international and commodity exposure products.