What Are Custom Basket ETFs?

Exchange-traded funds are baskets of stocks or bonds, usually passively managed, and seek to match an underlying benchmark index. Custom basket exchange-traded funds (ETFs) take 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 their target index or allocation constraints when it benefits the ETF and shareholders.It also gives ETF managers additional flexibility when buying and selling stock and other assets for their funds.

The ETF Rule

When investors buy or sell 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.

Before the ETF rule, funds were required to buy and sell asset baskets in precisely the same proportion as required by the fund. 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 taxation. Custom basket ETFs customize buying and selling strategies to optimize shareholder profits.

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.

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.

A fund manager’s custom basket strategy can make a difference in fund performance. For example, when comparing several S&P 500 funds, investors may see a slight difference in results across fund managers.

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

The Bottom Line

The “ETF Rule," adopted by the SEC in 2019, allowed for custom basket ETFs. Custom basket exchange-traded funds give managers flexibility when buying and selling assets to customize asset purchases outside a target index or allocation.