What Is Synthetic ETF? Intro and Guide for Beginners

Synthetic ETFs are less common than traditional ETFs, but they play an important role in certain markets. They often appear in discussions about tracking accuracy, access to hard-to-reach assets, and counterparty risk.

For investors who only know physically backed ETFs, synthetic structures can feel confusing or even risky at first glance.

Understanding synthetic ETF meaning, how they work, and seeing a synthetic ETF example helps investors decide when these products make sense and when extra caution is needed.

Understanding Synthetic ETFs

A synthetic ETF is an exchange-traded fund that replicates the performance of an index using financial contracts, usually swaps, instead of owning the underlying securities.

Rather than buying all the stocks or bonds in an index, the ETF enters an agreement with a counterparty to receive the index return.

The goal is still the same as a traditional ETF: track an index as closely as possible.

Why synthetic ETFs exist

Synthetic ETFs are often used when:

• The underlying assets are hard to access

• Trading costs are high

• Tax efficiency can be improved

• Precise index tracking is difficult with physical holdings

They are more common in certain regions and asset classes.

How Synthetic ETFs Work

Synthetic ETFs rely on contractual arrangements.

The role of swaps

The most common structure uses total return swaps.

The ETF holds a basket of collateral assets and enters a swap agreement with a bank or financial institution. The counterparty agrees to pay the ETF the return of the target index.

In exchange, the ETF pays the return of its collateral basket or a fee.

Collateral structure

Synthetic ETFs still hold assets.

These assets serve as collateral to reduce counterparty risk. The collateral may or may not be related to the index being tracked.

Regulations often require the collateral to be diversified and marked to market.

Unfunded vs funded swaps

Some synthetic ETFs use unfunded swaps, where collateral remains separate from the swap.

Others use funded swaps, where collateral is transferred to the counterparty. Unfunded structures are generally considered safer.

Synthetic ETF Example

Examples make the structure clearer.

Example of a synthetic ETF

A synthetic ETF tracking a foreign equity index may not buy the actual stocks.

Instead, it holds a diversified basket of liquid securities and enters a swap agreement with a bank. The bank delivers the index return daily, minus fees.

The investor experiences index-like performance without the ETF owning the actual shares.

Where synthetic ETFs are commonly used

Synthetic ETFs are often used for:

• Certain international equity markets

• Commodity indexes

• Hard-to-access or illiquid markets

In these cases, physical replication may be inefficient or impractical.

Advantages of Synthetic ETFs

Synthetic ETFs offer several potential benefits.

Improved tracking accuracy

Because returns are delivered via swaps, synthetic ETFs can closely match index performance.

They may avoid tracking issues caused by trading costs, dividend withholding taxes, or rebalancing friction.

Access to difficult markets

Some markets are expensive or restricted for foreign investors.

Synthetic ETFs provide exposure without directly owning the underlying assets.

Potential tax efficiency

In some jurisdictions, synthetic structures reduce dividend withholding taxes.

This can improve net returns compared to physically replicated ETFs.

Lower transaction costs

Because the ETF does not need to trade all index constituents, trading costs can be lower.

This can be especially useful for broad or frequently rebalanced indexes.

Risks of Synthetic ETFs

Synthetic ETFs carry unique risks.

Counterparty risk

The main risk is counterparty risk.

If the swap counterparty fails, the ETF may not receive the index return. Collateral helps mitigate this risk, but it does not eliminate it entirely.

Complexity and transparency

Synthetic ETFs are more complex than traditional ETFs.

Understanding swap structures, collateral quality, and counterparty exposure requires more due diligence.

Regulatory differences

Rules around synthetic ETFs vary by region.

Disclosure standards, collateral requirements, and protections may differ depending on jurisdiction.

Perception risk

During market stress, investors may avoid synthetic products.

This can impact liquidity and pricing, even if the structure is sound.

Synthetic ETFs vs Traditional ETFs

The key differences lie in structure, not purpose.

Asset ownership

Traditional ETFs physically hold the underlying securities.

Synthetic ETFs use derivatives to replicate performance without owning those securities.

Tracking behavior

Synthetic ETFs often track indexes more precisely.

Traditional ETFs may experience small tracking differences due to costs and taxes.

Risk profile

Traditional ETFs carry market risk.

Synthetic ETFs carry market risk plus counterparty risk. This added layer requires careful consideration.

Use cases

Traditional ETFs are preferred for simplicity and transparency.

Synthetic ETFs are often chosen for efficiency or access, especially in specific markets.

How Investors Evaluate Synthetic ETFs

Due diligence is essential.

Reviewing collateral quality

Investors should examine:

• Type of collateral

• Diversification

• Frequency of rebalancing

High-quality collateral reduces risk.

Understanding counterparty exposure

Some ETFs limit exposure to a single counterparty.

Others spread swaps across multiple institutions. Diversification can lower risk.

Comparing costs and tracking

Synthetic ETFs may have lower tracking differences despite similar expense ratios.

Looking at long-term performance relative to the index is important.

Conclusion

Synthetic ETFs are designed to deliver index returns using derivatives rather than physical ownership. They can offer precise tracking, access to difficult markets, and potential tax efficiency, but they also introduce counterparty and structural risks.

Understanding synthetic ETF meaning, how these ETFs work, and reviewing a synthetic ETF example helps investors decide whether the benefits outweigh the added complexity.

If you are comparing different ETF structures, exploring both synthetic and traditional ETFs on the Gotrade app can help you understand how each behaves in practice and which structure fits your investment goals.

FAQ

What is a synthetic ETF?
A synthetic ETF tracks an index using derivatives, usually swaps, instead of holding the underlying assets.

Are synthetic ETFs risky?
They carry additional counterparty risk, but collateral and regulation help reduce this risk.

Do synthetic ETFs track indexes accurately?
They often have very low tracking differences due to swap-based replication.

Are synthetic ETFs suitable for beginners?
They require more understanding and are generally better suited for informed investors.

Reference:

• Investopedia, Synthetic ETFs, 2026.

• Vanguard, What you need to know about physical and synthetic ETFs, 2026.