An exchange-traded fund (ETF) that does invest in assets in indirect way, through certain contracts or structures. For example, instead of investing directly in a commodity (crude oil, copper, gold, silver, etc.) a synthetic ETF will be constructed by holding a series of oil futures contracts.
As opposed to a physical ETF, a synthetic ETF, investing in stocks, does not hold the underlying stocks that it aims to track. Instead, it uses different arrangements or contracts (derivatives such as swaps, futures, or options) to replicate the performance of its underlying index. A synthetic replica of the underlying index is created by means of a contract entered into between the ETF manager and a financial counterparty. The counterparty will provide the ETF with a return linked to the performance of the chosen index.
The performance of the index is set against that of the actual assets held by the ETF manager. If the index performs better, the difference in financial performance is paid by the counterparty. In the opposite scenario, if the performance of the index is lower than that of the physical assets, the ETF manager has to pay the difference to the counterparty. For that purpose, it therefore sells physical assets to pay the counterparty.
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