Funded vs Unfunded Swap ETF Structures

A synthetic ETF doesn't buy the index's stocks directly — instead it holds some collateral and enters a total-return swap with a bank, receiving the index's return in exchange for a fee. There are two ways to structure this. In an unfunded swap, the fund keeps its cash and buys a basket of substitute securities as collateral, then swaps only the difference in performance between that basket and the target index with the counterparty bank — so at any moment the fund's actual exposure to the bank going bust is limited to that performance gap, which regulation typically caps around 10% of fund assets. In a funded swap, the fund hands its cash directly to the bank, which promises to pay back the index return on demand — the fund's exposure to the bank's failure is now closer to 100% of assets, unless separate collateral is posted back to the fund to offset it.

The distinction matters entirely in a counterparty default. Under an unfunded structure, if the swap bank collapses, the fund still holds its substitute-securities basket and has only lost the swap's mark-to-market gap. Under a funded structure without independent collateral, the fund's cash could effectively be sitting on the bank's balance sheet, exposing investors to the same kind of loss that hit unsecured creditors of a failed bank.

Modern synthetic ETFs mostly use unfunded swaps with daily collateral posting specifically to limit this counterparty exposure, following regulatory pressure after the 2008 crisis made the funded structure's risks obvious.