What is synthetic replication?

Synthetic replication refers to the construction of a type of Exchange Traded Fund (ETF) know as a synthetic ETF. This type of ETF uses swaps and other derivatives to achieve accurate replication of a given asset, as opposed to a physical ETF which is constructed using the asset itself.

Where have you heard about synthetic replication?

As a private investor, you’ll have heard from your broker about the huge range of ETFs available for you to invest in. ETFs track everything from US stocks to emerging markets. When the tracked asset is illiquid or costly to hold, the ETF provider will use synthetic replication.

What you need to know about synthetic replication.

Synthetic replication – and the synthetic ETFs that use it – have both risks and benefits to investors, and you should be aware of these. The biggest risk is that the synthetic ETF provider must enter a swap transaction with a financial institution to deliver the market performance promised by the product. It – and you – are exposed to counterparty credit risk, although this can be mitigated with increased collateral. The benefits come with improved tracking on assets that are costly to hold physically. These include illiquid emerging market fixed income products and commodities that need to be warehoused.