Like a stock, an ETF trades on an exchange. An investor generally buys and sells shares of an ETF through their brokerage account, rather than placing orders with the ETF directly.
Authorized participants (APs) are large institutional investors (like market makers and banks) that transact directly with an ETF provider to create or redeem shares of an ETF. They do this through the creation and redemption process. This is a process where an AP delivers an in-kind basket of securities and cash in exchange for shares or creation units of the ETF (creation), or delivers shares of the ETF in exchange for an in-kind basket of the ETF’s underlying securities and cash (redemption).
The ETF manager determines the list of securities to include in the in-kind basket. One of the roles the AP plays in the creation process is to acquire the securities that the ETF manager has determined the ETF will accept in exchange for ETF shares. Before the rule, exemptive reliefs for active ETFs generally required creation and redemption baskets that represented a pro-rata basket of the ETF’s holdings.
By giving managers choice in the baskets they provide APs in the daily creation/redemption process, custom in-kind baskets can be used as part of a daily rebalancing process to improve expected returns. When the ETF receives or delivers in-kind baskets that represent pro-rata baskets of the underlying ETF, the composition of the ETF is not affected. However, custom in-kind baskets can be used to adjust the underlying holdings, potentially playing a useful role in the portfolio rebalancing process. Portfolio managers of ETFs can also rebalance their portfolios by executing trades directly in the market on behalf of the fund. Custom in-kind baskets give them another tool.
How and to what extent a manager takes advantage of the flexibility afforded by custom baskets largely depends on their investment proposition, approach to daily portfolio management, and the technology they have in place to manage the associated tradeoffs.
The mechanics of trading differ between mutual funds and ETFs, but the goal is the same—to minimize the impact of trading costs on the premiums that portfolio is seeking to capture. For ETFs, custom baskets are an additional tool that provides the manager with more choice in how to manage trading costs through the baskets they provide APs as well as the trading activity they engage in directly, such as rebalancing activity and the investment of cash received from dividends or other corporate actions or APs. For example, by taking into consideration liquidity in the custom baskets, ETF managers may be able to provide APs with baskets that involve lower transaction costs to assemble or liquidate vs. pro rata baskets. Lower transaction costs for APs can potentially result in smaller spreads on the ETF shares trading on the market, which benefits investors when they transact in the ETF on an exchange. The spread is the difference between the market’s best bid and best offer at any given time.
Creating intelligent custom baskets that use daily information from markets—while at the same time ensuring that the ETF continues to be managed toward its intended design—requires the ability to manage complex tradeoffs daily. Dimensional has technology and tools in place to evaluate these tradeoffs as well as a global Portfolio Management team with experience overseeing the daily process.
In the mutual funds we manage, our active implementation enables investor cash flows to be used for efficient portfolio rebalancing. Custom basket flexibility can allow us to use the ETF creation or redemption process for efficient ongoing rebalancing. Thus, just as in our mutual funds, we can use client trading activity to benefit all fund shareholders.