In September 2019, the Securities and Exchange Commission (SEC) approved Rule 6c-11 under the 1940 Act, which will allow most exchange-traded funds (ETFs) to operate without the expense and delay of obtaining an exemptive order. The new rule provides greater flexibility to all issuers looking to launch new products filed as open-end funds in a streamlined approval process with a quicker time to come to the market. The new rule applies to both index-based and actively managed transparent ETFs. This rule cannot be applied to leveraged/inverse ETFs, unit investment trusts, master-feeder funds or share class ETFs.
Perhaps one of the most overlooked items, and least understood by those looking to launch ETFs, is the ability to utilize custom baskets. Some ETF issuers were granted this previously in the exemptive application, and some weren’t. The new rule allows all passive and active transparent ETFs to make use of custom baskets.
The newly passed semi-transparent ETFs do not meet the 6c-11 requirements; however, NYSE/Natixis Actively Managed Solutions, Blue Tractor’s Shielded Alpha, and Invesco Capital Management have received approval from the SEC for the use of custom baskets in their proxy portfolio methodologies. Invesco’s approval came with the full approval of their “Substitute Basket” model that had previously been pending when SS&C published the whitepaper: Semi-Transparent Exchange Traded Funds: A Revolution in Active Management. In addition, T. Rowe Price and Fidelity have applied and are awaiting approval on their application for the use of custom baskets. Precidian’s ActiveShares has filed an application as well, but based on the requirements and the fact that the model was designed to be fully non-transparent, it remains to be seen if this will get approved since it would defeat the purpose of the methodology. And if they do find a path to do it, the basket would probably only be available to the Authorized Participant Representative. All applications state that the trust will be required to comply with the same rules under 6c-11 for custom basket policies and procedures.
What is a custom basket?
Per the SEC, a custom basket is any basket that differs from the standard basket issued on a daily basis for creation and redemption transactions initiated by Authorized Participants (APs). This is technically defined as a basket that has cash-in-lieu restrictions, full cash, a basket for rebalance purposes, or even a basket negotiated between the Trust’s portfolio manager and the end client. Per NSCC (National Securities Clearing Corp), a custom basket is typically one issued before the market opens and available to a particular counterparty, and a negotiated basket is usually issued during the trading day and not available to all; but in practice, the industry uses the two terms interchangeably. For this blog, we will focus on the custom basket as it relates to rebalances.
Why is the ability to have custom baskets so important for ETFs and who does it benefit?
The creation/redemption features in ETFs allow for important tax efficiencies that are not typically found in traditional open-end ‘40Act funds. By making use of custom baskets, particularly for rebalancing purposes, the ETF will not recognize capital gains on any of the appreciated securities within the custom redemption basket, since they are exchanged in-kind with the AP instead of realized (sold) within the fund. The ETF portfolio manager has the flexibility to select securities with a low tax basis to in-kind transfer out of the fund within the custom redemption basket. Importantly, this helps to avoid any dreaded taxable capital gains distributions for shareholders at year-end and defer those taxable gains to when they eventually sell the ETF. While an ETF’s dividends may still be taxable, the tax efficiency resulting from potentially not having to make taxable capital gain distributions helps to compound after-tax returns for ETF shareholders.
A rebalance custom basket is a “trade” event for the portfolio manager and is used to change the portfolio holdings pursuant to index changes or active management decisions. As such, authorized participants (APs) transact with the fund to help facilitate the portfolio changes for the rebalance through an in-kind exchange.
What do custom baskets mean for semi-transparent ETF models?
Under Rule 6c-11, every ETF is required to publish their standard creation/redemption basket every morning before the markets open for that day’s activity. Operationally, this is not a dramatic change. So whether it is a standard basket or a custom basket, it will need to be published daily for active or passive transparent ETFs to show the required basket for that day’s creation and redemption activity by LMMs and APs. The custom basket is transmitted to the NSCC under a unique CUSIP that is only available and visible to the AP/LeadMM (counterparty) that is facilitating the custom transaction with the fund.
In the case of the semi-transparent proxy models mentioned above, most refer to custom baskets with the nomenclature of “additional basket flexibility.” The approvals have stated this as “to use Creation Baskets that include instruments that are not included, or that are included with different weightings, in the Fund’s Proxy Portfolio.” Furthermore, the SEC has agreed to the applicants’ logic that this is a custom basket in accordance with Rule 6c-11; firms that receive approval under the additional basket flexibility must adopt and implement the written policies and procedures regarding the Fund’s utilization of a custom basket.
As mentioned above, the tax efficiency component of an ETF can be a powerful tool for active managers within a semi-transparent structure. Specifically, the semi-transparent ETF structures all generally refer to the use of “additional basket flexibility” within their features that active managers can utilize, which is important to highlight. You may be asking yourself, why does a proxy portfolio methodology need to have additional basket flexibility when, by the very nature of the structure, it has flexibility to begin with?
Each of the semi-transparent ETF structures with proxy baskets are very different, as we pointed out in the Semi-Transparent Exchange Traded Funds: A Revolution in Active Management whitepaper. That being said, the active portfolio manager on a semi-transparent ETF structure may wish to buy a security that is not part of the proxy basket or sell a security within the proxy basket without incurring additional transaction costs. The manager may determine that disclosing the new position or reducing the securities position in the proxy creation basket could allow for front-running on that desired trade; therefore, the manager could include it in the custom basket to be delivered in-kind to reduce those transaction costs and, similarly, help to increase after-tax returns for shareholders.
Will active managers utilize the “additional basket flexibility” within the new semi-transparent structures as much as the passive managers have in transparent structures? Given the multiple ETF proxy portfolio structures shielding active models, will one structure be more appealing to do custom baskets than the others? Only time will tell for sure and, at this point, we have yet to see any custom basket “heartbeat” trades for those structures that have the exemptive relief to do so. However, the ability to utilize custom baskets will also depend on the active manager’s trading strategy and the immediacy of the trade. Custom baskets can take two business days to take effect and are delivered at closing prices. Some active managers do not have that sort of patience or flexibility within their strategy. This, too, will be interesting to see how active managers potentially choose tax efficiency over immediacy for each trade, but that sort of optionality on strategy is also what makes the ETF market so efficient for investors and their investment choices.
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