Synthetic replicating ETFs

Synthetically replicating ETFs (Exchange-Traded Funds) are index funds that replicate an index without buying the underlying assets of the index (e.g. shares).
Synthetically replicating equity funds instead compose their portfolio from a specific basket of securities (at least 90%) and a (collateralised or even over-collateralised) swap (max. 10%). A synthetically replicating ETF constructed in this way thus holds a basket of collateral instead of the individual securities of the index. Via the swap (i.e. an exchange transaction) with a partner, the performance of the basket of collateral is exchanged for the performance of the actual underlying index.
With synthetic replication, fund companies can replicate an index more precisely, i.e. with no or significantly less tracking error than with some physical ETFs. Moreover, some indices, e.g. on commodities or on certain emerging markets such as India, can only be replicated via synthetic ETFs, as the underlying assets cannot be bought or held in an economically viable way. Oil and natural gas are an example of this.
The inclusion of one or more parties in the SWAP transaction creates an additional counterparty risk (default risk) vis-à-vis the swap counterparty.
In addition to synthetically replicating ETFs, there are also physically replicating ETFs.