The fund holds a basket of collateral assets and enters a total-return-swap in which the counterparty pays the index return and receives the collateral basket's return plus a fee. Tracking can be very tight because the swap pays the index exactly, including dividends at treaty rates the fund could not otherwise obtain.
The trade-off is counterparty-risk. If the swap provider fails, the fund is left with the collateral, which is marked and often over-collateralised but is not the index. UCITS rules cap uncollateralised exposure to any single counterparty at 10% of net assets, and most providers reset the swap far more frequently than that limit requires.
Synthetic structures are most common where physical access is difficult or tax-inefficient. Check the collateral schedule and the number of swap counterparties before treating two same-index funds as interchangeable.
Related: total-return-swap, counterparty-risk, index-replication, ucits, collateral, tracking-difference