Authorized Participants are the wholesalers of an ETF. Although it might not be the top concern for a new ETF issuer in the first instance, eventually a serious ETF franchise will want its wholesale channel to work optimally. Working well with APs can differentiate an ETF issuer looking to develop a strong brand. It can reflect positively on how the market perceives the ETFs, and it can make a valuable contribution to building a quality franchise.

Custom baskets and negotiated orders

Striking the agreement to distribute the ETF is just the beginning. Integrating APs with the issuer’s portfolio management operations can be as simple as publishing a single basket – usually a slice of the fund’s holdings – for each fund on each day. Custodians commonly offer a simple service which provides this. It allows an ETF issuer to come to market with little or no integration between its portfolio management and capital markets operations.

The more illiquid or difficult to access the basket securities are, the less likely it is that this approach will be satisfactory. Although a custodian is well placed to adjust a basket for corporate actions, they have limited knowledge of security restrictions and same-day rebalance activity.

There are many good reasons why it is preferable to customize baskets. Working out the best basket shape is a collaborative process, balancing what the fund needs to minimize its tracking error with what the AP can deliver from inventory. An active ETF may have more flexibility to consider opportunities presented by an AP’s inventory than an index ETF. Custom baskets are the norm where availability of stock is not certain as may happen frequently, for example, in fixed-income ETFs.

If complex customization is desired, this must be negotiated bilaterally between AP and issuer and separately communicated to the custodian. The strongest ETF franchises work with multiple APs and routinely customize the basket exchanged with them.

Tax efficiency

In the US, minimization of capital gains distributions is another reason to work efficiently with APs. A key advantage that ETFs have over mutual funds is that the issuer may cooperate with an AP and use the in-kind mechanism to achieve sales of securities without triggering a taxable event. This gives rise to what is known as a heartbeat trade, since it involves the AP creating standard units in the ETF and shortly afterwards redeeming them through customized units which hold securities showing a gain. Determining what goes into the customized basket requires knowledge of the tax lot history of the holdings.

Technology and Tools

Since custom baskets are not simply a slice of the fund, accepting them shifts the risk position of the fund. If you are lucky enough to have a busy ETF with a lot of create/redeem activity, keeping track of your fund’s true position as you accept various custom baskets becomes a major concern. Unfortunately, most portfolio management systems are of little help here.

The first steps toward a flexible capital markets approach can be undertaken using email and spreadsheets. Bloomberg’s BSKT is an established communication channel for basket compositions available to those who have access to a Bloomberg terminal. There are other proprietary solutions for connecting with APs, but little that supports the whole basket workflow. Integration of these components with the in-house IBOR is desirable. The most basic integration is the ability to upload or copy/paste basket holdings. However, this results in a homespun solution that significantly adds to the portfolio manager’s workload.

Ryedale’s Solution

Ryedale has been delivering ETF-specific functions in its portfolio management software since 2016. The system has been engineered from the ground up to give asset managers tools to deal with index and ETF management. It can streamline many tasks a portfolio manager needs to execute in an ETF, including customizing baskets, sharing basket compositions with APs as part of a negotiation process, keeping track of all pre- and post-order activity, and automating the communication of PLF/PCF with the custodian. The Ryedale IBOR incorporates tax-lot information and tools to generate tax-efficient heartbeat trades.

To find out more about Ryedale's ETF capital markets solutions, Contact us to request a demo.

Nov 29, 2022

London, United Kingdom

About Ryedale

Ryedale delivers a modern, cloud-based, full-service IT platform for serious investment businesses. Its software provides industry-leading support for model-driven and quantitative investment strategies, embracing index investments, smart-beta, custom indices, asset allocation, overlays and hedging. Ryedale's customers include several globally recognized asset management firms and institutions. For more information about Ryedale investment management solutions, please visit