In the UK you have the option of investing in synthetic tracking funds. The risks of physical-replicating ETFs (exchange-traded funds) have caused people to create an alternative fund, called the synthetic tracker fund. In essence, this features just one crucial change from a physical replicating fund.

A synthetic tracker fund following the S&P 500 does everything the same as the conventional index tracker, but its core holdings aren’t the stocks inside the index but instead what’s essentially an IOU.

The issuer may be a large investment bank that already holds all those stocks within the S&P 500 as part of its normal trading portfolio. The bank’s trading desk simply issues an IOU to the fund, which says that they promise to pay out on the return from investing in the index.

As collateral they issue what’s called a swap (a kind of complicated IOU wrapped up within a contract), which is that promise measured against the return from the index as well as collateral to back-up the promise. That collateral can come in many different shapes and sizes and be whatever stock they hold within their portfolio at the time.

Imagine that a synthetic tracker is following the S&P 500 over the next year. The ETF fund starts with a market capitalisation of US$100 million when the S&P 500 index is at 1,400. One year later the index has gone up 10 per cent and the index level is now 1,540. The fund should now be valued at $110 million.

Behind the scenes the value of the swap and the associated collateral backing up this return has simply increased from a total of $100 million (probably comprising $90 million in collateral and a $10 million swap contract) to $110 million ($99 million in collateral and $11 million swap contract).

The beauty of this synthetic tracking is that no tracking error whatsoever need exist and the issuer can also underwrite to pay out the total net return including dividends (after tax has been accounted for). Costs may also be substantially lower as a result and crucially this synthetic swap is very efficient in dealing with less liquid markets.

Less developed markets and alternative asset classes are best tracked using synthetic ETPs.

The downside of a synthetic tracker is immediately obvious: as the investor, you’re taking a risk with that IOU. In essence you’re gambling on the credit worthiness of the bank issuer, which introduces the concept of counterparty risk, the risk that the counterparty (in this case the bank) will not live up to its contractual obligations.

The bank does its very best to mitigate that risk for you by offering up that collateral, and regulators probably force the bank and the issuer to limit that exposure to the swap contract to 10 per cent (at most) of the value of the fund.

But you can’t get away from the fact that you’re taking a risk. As an investor you need to balance the potential reward of lower tracking errors, access to new markets and lower expenses against the counterparty risk.