Passive fund managers can use synthetic replication to track an index through derivatives like swaps. In this arrangement, the fund agrees to pay a pre-defined return (e.g., LIBOR or a fixed rate) to a counterparty in exchange for the counterparty delivering the total return of the index. This approach allows the fund to replicate index performance without holding the physical securities, reducing costs and eliminating tracking error.
[Reference:, ICWIM, Topic: Passive Fund Management and Synthetic Replication., UCITS guidelines on the use of financial derivatives for replication., , , ]
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