Passive fund managers use synthetic replication via total return swaps to track an index without directly holding the underlying securities.
How It Works:
The fund manager enters into a swap agreement with a counterparty (e.g., an investment bank).
The fund pays a pre-defined return (e.g., cash or fixed rate) to the counterparty.
In exchange, the counterparty provides the exact return of the target index.
Advantages:
Lower trading costs compared to full replication.
More efficient tracking of the index, especially in emerging markets.
Example: An ETF tracking the S&P 500 may use swaps to receive the total return of the S&P 500 index without buying all 500 stocks.
???? Reference: CFA Institute (Index Replication), CISI Wealth & Investment Management (Passive Strategies).
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