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A synthetic ETF is a type of investment strategy that is designed to function in a manner that is very similar to a real exchange-trade fund. The process for this strategy usually involves arranging derivatives in a way that provides similar potential for returns. There is a difference of opinion among investors as to whether this type of arrangement is at least as good as an exchange-traded fund, or if the configuration of this sort of investment approach has a better chance of creating false expectations among investors.
The basic structure of a synthetic ETF relies on a derivative strategy that is known as a return swap. With this approach, the investor works with a counterparty to develop a contract that allows the investor to receive a flow of cash in return for the commitment to tender the amount of return of the fund’s index within a specified time frame. This is different from a typical exchange-traded fund in which the investor must actually purchase at least a majority of the securities involved with that index. Since the investor is not purchasing anything per se, but is anticipating making a profit based on the future performance of that index, the deal is considered to be synthetic.
Different exchanges have regulations that govern when and how a synthetic ETF can be traded. The Hong Kong Exchange, which has long allowed this type of investment strategy, has put in place stringent regulations that must be observed in order to make use of this strategy. In part, those regulations are based on concerns that some investors may not fully grasp how this type of investment opportunity actually functions, and may not quite understand what is happening if the investment does not perform in a manner similar to a more conventional exchange-traded fund.
While the level of risk associated with a synthetic ETF is not generally considered greater than with any other type of similar arrangement, some advisors urge investors to avoid contracts of this type, especially if the investors involved have little to no experience with this type of investment strategy. Even if the investors in question have a considerable amount of experience with standard ETFs, this may not be sufficient to grasp the similarities and the differences between a regular ETF and a synthetic one. Unless the investor has a firm grasp of how the synthetic ETF is structured and what may or may not happen, and is prepared to take on the risk associated with the index involved, going with an approach that is less complicated may be a better idea.