Custom Basket ETFs

What Are Custom Basket ETFs?

Custom basket exchange-traded funds (ETFs) are a type of investment fund that takes advantage of the ETF Rule passed by the U.S. Securities and Exchange Commission (SEC) in 2019. The rule permits ETF managers to customize asset purchases outside of their target index or allocation constraints when it’s in the best interest of the ETF and its shareholders.

The custom basket rule gives ETF managers additional flexibility when buying and selling stock and other assets for their funds. Before the rule, funds were required to buy and sell asset baskets in precisely the same proportion as required by the fund. This sometimes resulted in buying and selling underlying securities at less-than-ideal market prices. Custom basket ETFs can customize their buying and selling strategies to optimize shareholder profits.

Understanding Custom Basket ETFs

To better understand custom basket ETFs, here’s an example: When someone buys or sells shares of an index fund ETF, they may buy or sell existing shares from someone else. However, the fund has to issue new shares or eliminate shares in some cases. At the same time, the fund must buy or sell underlying assets that make up the index to keep it accurately weighted.

Prior to the 2019 ETF Rule, funds typically bought or sold stock through an automated process using larger orders known as a basket trade. The fund would buy a basket of shares in the fund’s accounts as shares were issued and sell a basket of shares when redeemed.While this process worked, it did not consider market fluctuations or taxes.

Custom baskets give fund managers some control over which shares they buy and sell, as well as the timing—even if that means going slightly out of alignment with the underlying index or target allocation. This is permitted only when a custom basket is in the best interest of the fund and its shareholders.

Special Considerations

If you’re looking to buy an ETF index fund, a fund manager’s custom basket strategy can make a difference in fund performance. For example, if you are comparing several S&P 500 funds, you may see a slight difference in results across fund managers.

Advantages and Disadvantages of Custom Basket ETFs

When used effectively, custom basket ETFs can benefit fund managers and investors. An improved trading strategy may improve tax efficiency, lower trading costs, and help the fund take advantage of opportunities to buy or sell at a more favorable price.

However, this also means that the fund may not follow the index or allocation model precisely. If the fund manager employs custom baskets ineffectively, it could cost shareholders instead of rewarding them.