Exchange traded funds are actually a little more clever than that. From the fund’s perspective, it doesn’t redeem fund shares for cash. The ETF has a number of “authorized participants” which are banks that can create new shares of the ETF. To create new shares of the ETF, they purchase the underlying shares in large quantities (called a “creation unit”) and provide them to the ETF, which then gives back the authorized participant the matching number of ETF shares. So for an S&P 500 ETF, the bank would first purchase all of the underlying shares of the S&P500 in the right quantity (generally a very large quantity) and provide them to the ETF, and the ETF would hand them X number of ETF shares that the bank can now sell. The banks make money through arbitrage, by buying and selling creation units when they are out of alignment with the price of the ETF.
A synthetic fund is slightly different from your description. A synthetic index is when you use derivatives to replicate the performance of an index fund. So rather than taking your $100 million charitable endowment and invest it in an index, you take your $100 million dollars and invest it in treasury securities, then enter into a swap contract that will replicate the perfomance of the index. Future payments go into your fund, and future shortfalls are removed from your fund. It can also be done with futures and the like.
Exchange traded funds are actually a little more clever than that. From the fund’s perspective, it doesn’t redeem fund shares for cash. The ETF has a number of “authorized participants” which are banks that can create new shares of the ETF. To create new shares of the ETF, they purchase the underlying shares in large quantities (called a “creation unit”) and provide them to the ETF, which then gives back the authorized participant the matching number of ETF shares. So for an S&P 500 ETF, the bank would first purchase all of the underlying shares of the S&P500 in the right quantity (generally a very large quantity) and provide them to the ETF, and the ETF would hand them X number of ETF shares that the bank can now sell. The banks make money through arbitrage, by buying and selling creation units when they are out of alignment with the price of the ETF.
A synthetic fund is slightly different from your description. A synthetic index is when you use derivatives to replicate the performance of an index fund. So rather than taking your $100 million charitable endowment and invest it in an index, you take your $100 million dollars and invest it in treasury securities, then enter into a swap contract that will replicate the perfomance of the index. Future payments go into your fund, and future shortfalls are removed from your fund. It can also be done with futures and the like.