Synthetic replication is a less popular form of indexing that involves derivatives to track an underlying index. Instead of buying all the securities of an index, synthetic replication entails the use of an investment dealer to swap the performance of the index for a flat fee. For example, if the index increases, the fund receives a payment from the investment dealer based on the value of the gain. If it decreases, the fund pays the investment dealer the value of the decrease. This strategy is more common in ETFs than in mutual funds, but has seen a drop-off since 2010 when the U.S. Securities and Exchange Commission (SEC) prevented the creation of new synthetic ETFs.
The advantage of this approach is that the fund doesn’t incur any purchasing or selling expenses. The downside is that the fee paid to the investment dealer is subtracted from the fund’s overall return. Additionally, synthetic portfolios are inefficient for developed liquid markets like the S&P 500 and are often used when dealing with emerging markets.