Factor-based optimisation and the creation/redemption mechanism of fixed income exchange-traded funds

Abstract

Fixed income exchange-traded funds (ETFs) trade on organised exchanges, often with narrow spreads, liquidity and pre- and post-trade transparency. The tremendous success of fixed income ETFs relies critically on the efficient functioning of the ETF creation-redemption mechanism which drives the funds' market price to stay closely in line with the underlying values of the bond portfolios they represent. Creation of fixed income ETFs faces challenges though because of the less liquid nature of the markets for many bonds. In this article, we explain how custom fixed income baskets can be used with exchange-traded funds in a systematic, auditable and repeatable manner. We use factor-based optimisation to create ETF baskets for one or more ETFs and with one or many counter-parties. We conclude that optimisation can improve the efficiency of ETF basket creation, which in turn induces higher liquidity and tighter spreads, benefitting investors.