Synthetic ETFs – When They Make Sense

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Synthetic ETFs are exchange-traded index funds that replicate the performance of an index through so-called swaps—i.e., exchange agreements with a bank or other financial institution—without physically purchasing the stocks or bonds in the index. These products were long criticized, especially during and after the 2008 financial crisis, when the role of complex financial instruments and anything related to derivatives came under scrutiny.

The debate around synthetic ETFs—also known as swap ETFs—is closely tied to how they work. Specifically, it concerns their complexity and what’s known as counterparty risk. To understand this, it’s worth taking a look under the hood of these ETFs.

Synthetic ETFs differ fundamentally from physically replicating ones: while physical ETFs actually buy the securities in an index, synthetic ETFs achieve the desired return through a swap agreement—technically referred to as a “total return swap.” In this setup, a bank typically commits to delivering the ETF the exact return of the reference index. In return, the ETF passes on the performance of a basket of securities it holds to the bank—completing the swap. The bank retains only a small fee, the swap fee, for the transaction. These arrangements allow ETFs to efficiently replicate markets that are hard to access or come with high trading costs—something physical ETFs can’t always do.

However, synthetic ETFs are dependent on their swap partner—in this case, the bank. This is where the often-feared counterparty risk comes in. Theoretically, the bank could default, meaning the ETF might temporarily not receive the promised return. But there are safeguards in place that clearly limit and make this risk transparent.

Today, synthetic ETFs are subject to clear regulatory requirements: in Europe, counterparty risk is capped at 10% of the fund’s assets.¹ In practice, this residual risk is often reduced even further: the bank acting as the swap counterparty must post high-quality collateral such as government bonds or liquid equities—often even overcollateralized by 8–20%.² Additionally, the value of the swaps and the collateral is regularly—usually daily—reviewed and adjusted to keep default risk as low as possible. Information on the composition and valuation of the collateral basket is typically published daily by ETF providers, allowing investors to assess the current risk situation. As a result, synthetic ETFs are now not only significantly more transparent but also better secured than they were before the financial crisis.

Structural Advantages in Specific Markets

But what are the actual advantages of the synthetic replication method? The strongest argument is likely the particularly precise and efficient index tracking. A key quality metric here is the so-called tracking error. This figure indicates how much an ETF’s return deviates from that of its reference index—the lower the value, the more accurately the fund tracks its benchmark. While physical ETFs may experience deviations due to rebalancing or withholding tax deductions, the swap mechanism in synthetic ETFs helps minimize these effects in certain markets. According to a study comparing replication methods, synthetic ETFs on average show the smallest deviations from their reference index.³

Beyond the usual arguments, there are also special cases. A rare example is Chinese mainland stocks (A-shares), which are difficult to access from abroad due to trading restrictions. Synthetic ETFs not only provide access here but can even benefit from market inefficiencies that are reflected in the ETF’s return. Historically, synthetic ETFs have been able to generate additional returns in this area that exceed the pure index performance. The result: these ETFs have regularly outperformed their benchmark index.⁴ Another example is large U.S. stock indices like the S&P 500, which includes the largest publicly traded companies in the U.S. Recently, synthetic ETFs have consistently delivered better returns here than their physical counterparts. The reason: withholding taxes are treated differently at the fund level for physical ETFs than for synthetic ones. As long as this remains the case, it positively impacts the returns of the synthetic ETF variant.

A Hybrid Innovation

While the debate over physical versus synthetic ETFs is nothing new, a recent innovation has brought fresh momentum to the market. The fact that both types have their merits is demonstrated by the first hybrid ETF, which combines the advantages of both replication methods in a single product: hybrid ETFs use synthetic replication where the fund management expects an advantage. In all other markets, the physical method is used—a significant advancement for the ETF product landscape.

All opinions reflect the current assessment, which may change without prior notice. Forecasts are based on assumptions, estimates, views, and hypothetical models or analyses that may prove incorrect. Past performance is not a reliable indicator of future results.

Source: DWS International GmbH; as of 19.09.2025

¹ EUR-Lex, 32009L0065, Article 52, retrieved on 23/09/2025, https://eur-lex.europa.eu/legal-content/DE/TXT/HTML/?uri=CELEX:02009L0065-20240109

² justETF, "How Synthetic ETFs Reduce Counterparty Risk", retrieved on 23/09/2025, https://www.justetf.com/de/news/etf/wie-synthetische-etfs-das-kontrahenten-risiko-reduzieren.html

³ Szmigiera, M., “Physical versus Synthetic Exchange Traded Funds. Which Replication Method is Better?”, retrieved on 23/09/2025, https://www.scirp.org/journal/paperinformation?paperid=80714

⁴ This statement is based on the positive tracking difference—that is, the difference between the fund’s performance and the return of the reference index—of the Xtrackers CSI300 Swap UCITS ETF 1C. The ETF tracks Chinese A-shares and achieved higher performance than the reference index (CSI 300 INDEX TR) for seven consecutive years. Past performance is not a reliable indicator of future performance. Historical performance can be reviewed here: https://etf.dws.com/de-de/LU0779800910-csi300-swap-ucits-etf-1c/