Fixed Income ETFs: Empowering New Managers to Succeed
Sarah Cummings
June 21st, 2022
On September 26th, 2019 the SEC voted to adopt a new rule and form amendments designed to modernize the regulatory framework for exchange-traded funds (“ETFs”). This rule (6c-11/ETF Rule) has spurred greater competition and innovation in the ETF marketplace by lowering the barriers to entry. Specifically, it did so by permitting ETFs that satisfy certain conditions to operate within the scope of the Investment Company Act of 1940 (the “Act”) and to come directly to market without the cost and delay of obtaining an exemptive order, replacing the legacy system of hundreds of individualized exemptive orders with a single rule .
Viewed favorably by the biggest players in the industry, the adoption of the rule (and subsequent compliance deadline of December 2020) transformed the Fixed Income ETF space in particular, opening the door for a considerable increase in the size of the market. At the same time that the rule created new opportunities, it also introduced challenges and complexities that have kept some prospective issuers on the sidelines and prevented others from reaching their full potential. The challenges and complexities are not insurmountable, however. Decameron’s affordable toolkit can empower prospective (and existing) ETF managers to make the most of the Fixed Income ETF opportunity.
The Rule: The rule provision with the biggest impact on prospective (and existing) Fixed Income (versus Equity) ETF issuers was the permitted use of creation (redemption) “baskets” that do not reflect a pro-rata representation of the fund’s portfolio or that differ from the initial basket used in transactions on the same business day (“custom baskets”). Prior to the passing of the rule, the big three issuers (BlackRock, State Street and Vanguard) were permitted to use custom baskets as part of their portfolio management process. In practice, a custom basket could mean accepting a stratified sample of ~40 bonds in exchange for shares of a fund that tracks an index with 2,000+ bonds. For the rest of the market, portfolio management looked much more similar to the practices of closed end fund managers. As a result, smaller managers were not able to take advantage of the many benefits of ETFs, such as tax efficiency, secondary market liquidity, and a well-functioning primary market (ETF basis minimized). The advantage of having a custom basket relief created a moat around the issuers who had it, challenged those who did not, and discouraged many from entering altogether.
The Challenges: Though potentially transformative, the use of custom baskets introduces a number of unique challenges into the already complex Fixed Income portfolio management process.
Custom Basket Screening: A custom basket is a type of in-kind creation (redemption) method where securities are exchanged for shares of an ETF. This differs from a cash creation (redemption) where cash is exchanged for shares of an ETF (or vice versa). In the case of a cash creation (redemption), the ETF portfolio manager goes to the open market and buys (sells) securities that replicate the characteristics of the fund, incurring transaction costs and potential tax consequences along the way. Oftentimes a portfolio manager can rely on the support of a trading desk and a longer time period/benchmark to buy (sell) when dealing with cash. When in-kind and specifically custom in-kind creations (redemptions) are introduced into the equation, ETF portfolio managers require tools to screen custom basket proposals relative to the existing (and future) needs of the ETF and construct custom baskets for dissemination (redemptions). These tools must be dynamic and accurate with the ability to generate insights in real-time to help the portfolio manager make critical decisions for the fund.
Pricing & Risk: Custom baskets attract arbitrageurs to the primary market of an ETF. Having a well-functioning primary market makes an ETF more attractive to a prospective end investor. However, it also places increased demands on the portfolio management function. Arbitrageurs seek to deliver the cheapest bonds they can in exchange for the shares of an ETF. The ability to accurately price any fixed income security across the credit and liquidity spectrum in real-time is a key piece of the custom basket “puzzle.” The absence of accurate pricing and valuation of both the fund and a proposed creation (redemption) basket could negatively impact a fund’s shareholders.
Policies & Procedures: A fund relying on Rule 6c-11 to operate as an ETF must set forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders, including the process for any revisions to, or deviations from, those parameters.
Where does Decameron fit in? We provide an intuitive and affordable package to address these challenges.
Custom Basket Screening: Decameron’s custom basket screening and optimization technology provides portfolio managers (working in tandem with ETF Capital Markets teams) with the ability to review and overlay multiple market participant proposals, use the create/redeem process for portfolio rebalancing and obtain real-time insights into basket composition relative to underlying index and fund. This is essential technology to ensure the ETF is equipped to make the most of custom basket relief and manage the new demands placed on the portfolio management function.
Pricing & Risk: Fixed Income portfolio management is challenging. The dynamics and incentives existing within the Fixed Income ETF market make it even more so. Learned directly from inventors of quantitative fixed income portfolio management, Decameron’s team has been continually updating its code base for 20+ years and has adapted it to incorporate new methodologies such as machine learning and neural networks. Real-time pricing creates actionable feedback that can be integrated into basket screening or used on a standalone basis. Decameron’s valuation engine can also be leveraged for backup calculation agent services.
Policies & Procedures: the use of Decameron as an independent third party is an ideal foundation for an ETF’s documented policies and procedures, a requirement for use of custom baskets.
"Basket of eggs" by 401(K) 2013 is licensed under CC BY-SA 2.0.
