Synthetic ETFs vs ETNs

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• SSEI Admin

Synthetic ETFs are pooled investment vehicles that are designed to replicate the returns of a benchmark/index

The word synthetic gives one the notion that we are “synthetically” creating an exposure to the asset class. There is no buying/selling of underlying involved.

In the case of Synthetic ETFs, an exposure is created to the index by entering into Derivatives such as Forwards, Futures, Options or Swaps

For instance, the fund managers can enter into a swap and agree to pay a fixed quarterly rate (say 3%) in lieu of returns on the Nifty 50 index.

Since a counterparty is involved, there is counterparty risk, liquidity risk and so on.

Exchange Traded Notes or ETNs are similar to ETFs in the sense that they trade on a centralised exchange and track a benchmark index. However there are some differences:

1. ETNs are senior,unsecured debt instruments issued by banks/financial institution that offer investors a bet on the direction of the index. Unlike ETFs they do not hold the underlying assets
2. An ETN promises to pay at maturity the full value of the index less any management fees. Much alike any other debt security, the investor is subject to the counterparty risk of the issuer

With the help of Synthetic ETFs and ETNs, an investor can get exposure to such assets that may otherwise be barred to him such as foreign stocks, cryptocurrencies, and the like

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