what they are

They’re ETFs that contain derivative contracts, not by physical securities.

using a subset of an index

Synthetic ETFs are the extension of an idea that’s been around for a long time.  Provides of index-tracking products, like index mutual funds, know that they don’t need to buy and sell every  component of the index they mimic in order to have an acceptable commercial product.  In fact, in the case of broad indicies, like the Russell 2000, the MSCI EAFE, or the S&P 500,results can be improved by transacting only in a subset consisting of the most liquid names.

After all, if an index has 1,000 constituents, the average weighting is .1%; for the bottom 10%, weightings will be much tinier.  So the act of a big index fund buying and selling may move the prices of those small stocks significantly.  The index fund’s tracking error, the difference between the performance of the fund and that of the index may well be smaller by dealing with a more liquid subset than with the entire index.

using futures

It’s also a standard technique for managers of all stripes to use a stock index future overlay on top of physical securities to protect their portfolios against adverse market movements over the time while they’re buying or selling to deal with large inflows or outflows.

combining these ideas

So conceptually it’s not much of a stretch to think of index-tracking products that contain no physical securities, but just derivatives contracts instead.  Voilâ!…synthetic ETFs.

mostly in Europe

So far, synthetic index ETFs are by and large products offered in Europe.

However, just as the concepts behind them are familiar, so too is the main risk associated they entail–namely, counterparty risk.  In the case of a “normal” index ETF, if the fund were to somehow fail, owners would still possess the underlying index securities.  Holders would recover net asset value–or something close to it–by selling the securities and receiving the proceeds.

In the case of a synthetic ETF, it’s possible that the investment bank or other counterparty could fail–as the recent financial crisis amply illustrates.  But this would leave the ETF owners with one side of a contract with a now-defunct entity.  At best, they could face a protracted bankruptcy proceeding before they’d be able to collect anything; at worst, they’d have nothing.

To address this issue, banks have been offering to collateralize their derivatives contracts, arguing that this will safeguard holders against counterparty risk.  But the collateral won’t be shares of the securities underlying the index.  To do this, banks would have to set up the expensive index fund infrastructure they’re trying to avoid by creating the synthetic ETFs in the first place.  Instead, shares in an EU-oriented index might be collateralized by a mortgage on an office building in Tokyo or a project loan to a government in Latin America.

The question is:  is this good enough?  Personally, I’d prefer not to have a “normal,” not a synthetic, ETF.