The Market Lens
The Custom Basket Game Changer
2021 is quietly shaping up to be the year of the nontransparent active (NTA) ETF.
Since the start of the year, five of these new vehicles have launched, while another five were filed for last week alone. After less than a year, there are now 23 NTA funds on the market, with $1.2 billion in total invested assets. I've rarely seen brand-new investment product types ever grow this quickly:
Source: ETF Action
I admit, when NTA ETFs first launched, I was skeptical. The virtues of portfolio transparency have been so well-ingrained in me that they might as well be Newtonian Law. Apples fall down. Knowing what you own is good. End of story.
Except it isn't that simple. Despite the fact that NTA ETFs conceal their daily portfolios and publish their holdings on a monthly or quarterly basis instead, mostly they've traded in the marketplace just like any other ETF. What few cost inefficiencies have arisen have remained small, and they stem from the same source: NTAs couldn't use custom baskets.
Until now, that is.
Earlier this month, Natixis became the first of the NTA ETFs to gain the SEC's approval for the use of custom creation/redemption baskets. Days later, Blue Tractor and Invesco got the greenlight, too.
It's no exaggeration to say that custom baskets are a game-changer. They've certainly proved so for transparent active ETFs. (Ever wonder why so many new ETFs these days are actively managed? There's a reason for that.)
Now that NTA ETFs can use custom baskets too, the mechanical edge that transparent ETFs had retained over their competition is wiped out. We're left with a real horse race now, between the traditional ETF structure that once disrupted the entire mutual fund industry; and the next-gen structure that mutual fund issuers hope will disrupt the ETF industry right back.
What's A Custom Basket, Anyway?
To understand why custom baskets are so important, first we should discuss how ETF shares are made ("created") and removed from the market ("redeemed").
Whenever an ETF issuer wants to make new shares of its ETF (or remove them from the market), they must turn to a special market maker known as an authorized participant (AP).
APs tasked with making new ETF shares will buy up a pro rata slice of all the securities inside that ETF's portfolio—known as a creation basket—then exchange those securities with the issuer for shares of the ETF (usually in large lots of 10,000 or 50,000 shares, known as a "creation unit").
To take shares off the market, they perform this process in reverse, delivering a creation unit's worth of ETF shares to the issuer, then receiving the same proportional redemption basket of the underlying securities in return.
This process is an in-kind exchange—meaning, shares are being exchanged for shares, rather than being sold at a profit or loss. As such, no taxable capital gains are realized. That's a big deal—more on why in a second.
Usually, this in-kind exchange takes place using creation/redemption baskets that proportionally match the ETF's underlying holdings. Custom baskets, however, don't match. They hold some variant portfolio instead: perhaps the same securities in differing amounts; or some securities swapped for cash and/or non-constituent names.
Why Custom Baskets Matter For ETFs
There are lots of reasons to want this kind of flexibility. For example, bond ETF issuers need custom baskets to create and redeem broad-based funds holding thousands of securities, hundreds of which may be too illiquid or expensive to procure at any given time. Or sometimes institutional investors want to buy a creation unit's worth of ETF shares (or more), but they simply don't have the securities on hand to create that pro rata slice of the fund's underlying portfolio.
Custom baskets can also be useful for tax management, allowing ETF issuers to ditch whichever shares of the underlying have appreciated the most without realizing any capital gains; while at the same time retaining the power to harvest losses for the securities that have depreciated.
That flexibility becomes especially beneficial during portfolio rebalances. By using custom baskets, ETF portfolio managers can vastly reduce the amount of buying and selling they must do in order to reflect quarterly index changes or even daily active management decisions. Swapping one security in a portfolio with another is as simple as putting the unwanted security in a custom redemption basket, while putting its replacement in a custom creation basket. Boom—new portfolio line-up, without having to sell any securities and possibly create a tax burden.
These ETF management trades are so common that they're known as "heartbeat trades," a term coined by FactSet's Elisabeth Kashner for the way they show up in daily ETF flows data like spikes in an EKG:
Source: ETF Action
How We Did It: In the ETF Data Explorer, type in any U.S.-listed ETF ticker and select "Period Flows" to see its daily flows data since inception.
Heartbeat trades are the secret sauce behind why the ETF vehicle is so extra tax efficient, and why ETF investors rarely, if ever, pay capital gains tax on their investments. And they absolutely depend on the ability an issuer's ability to use custom baskets.
The ETF Rule Changes Who Can Use Custom Baskets
For a long time, custom baskets were the provenance only of legacy issuers who'd obtained exemptive relief in the earliest days of ETFs. But in late 2019, the SEC passed the ETF Rule, a regulation streamlining the ETF launch process—and allowing any issuer adhering to it the use of custom baskets.
As a result, we've seen a flood of actively managed ETFs launch over the past eighteen months, coming from issuers new and old. Of the 433 new ETFs launched since the ETF Rule's passage in late Sept. 2019, 235 of them – or 54% -- are actively managed.
That is, in large part, due to the wider accessibility of custom baskets, which allow active, high turnover strategies to now take advantage of that rebalancing hot-swap and better harness the full tax efficiency of the ETF vehicle. (Read: "3 ETF Questions For 2021.")
However, the ETF Rule doesn't apply to nontransparent active ETFs. Like leveraged and inverse ETFs and unit investment trusts, NTA funds were deliberately left out of the SEC's ruling.
Hence why it's such a big deal that Natixis, Blue Tractor, and Invesco now have the approval to use custom baskets.
NTA ETFs Were Less Tax Efficient… Until Now
Currently, all three of these NTA ETF issuers process creations and redemptions for their products through the use of a secondary portfolio that camouflages the ETF's true portfolio holdings. Invesco and Natixis use portfolios consisting of proxy securities and weights, while Blue Tractor actually uses the ETF's real portfolio securities, but in slightly altered weights.
These proxy or (proxy-"ish") portfolios are published daily to allow APs to create and redeem. (The actual holdings of the ETF are only published once a quarter, just like a regular mutual fund.) But without custom baskets, APs were limited in their ability to select the most tax-advantageous or cost-effective trades.
Furthermore, using proxy portfolios introduces a secondary step into the ETF creation: Whenever an AP delivers shares of the underlying to create new ETF shares, the ETF portfolio manager would need to trade some or all of the shares in that (proxy) creation basket, so that they matched the securities in the secret, true ETF portfolio.
In practice, this extra step did appear to reduce the tax efficiency of NTA ETFs. Of the 15 NTA ETFs with track records long enough to potentially have paid out capital gains in 2020, at least four did—and perhaps as many as eight. (American Century's website is unclear about whether their NTA ETFs paid out capital gains, and if so, how much.) That's a rate of at least 27%; compared to 5% for transparent ETFs from the 12 largest issuers.
Sure, the capital gains distributions weren't huge: $0.03/share for the T.Rowe Price Growth Stock ETF (TGRW); $0.004/share for the Natixis U.S. Equity Opportunities ETF (EQOP). But they did exist, whereas for most transparent active ETFs, they don't:
Source: ETF Action, Fund Issuers
How Custom Baskets Help NTA ETFs
Now that NTA ETFs can also use custom creation/redemption baskets, APs will have far more flexibility to find the most cost-advantageous trades. In addition, the ETF portfolio manager will be able to utilize the same rebalancing tricks as transparent ETFs.
Not only will this likely bring down average trading spreads (which are already pretty low, at 0.15%), but they're likely to make these annual capital gains distributions much less frequent.
Also, remember how I said that custom baskets were a necessity for many fixed income ETFs? Now that NTA ETFs can use custom baskets, it opens up the possibility of ETF issuers using this structure for big, diversified, actively managed bond ETFs, too. Which might just be a marriage made in heaven: Active management has a long history in fixed income, especially among the mutual fund issuers who have been gravitating toward the nontransparent active structure.
Will this actually lead to an uptick in assets for nontransparent active ETFs? Only time will tell, of course. But if any single behind-the-scenes development could blow wind into their sails, this was it.
Now that the plumbing between nontransparent and transparent ETF structures is mostly the same, we'll get to find out how much investors really care if they're able to see water flowing through the pipes.
Lara Crigger is the Editor-in-Chief of ETF Action. Contact her at firstname.lastname@example.org
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