Microstructure implications of ETF arbitrage with custom baskets

Exchange-traded funds (ETFs) are typically considered to be passive investment vehicles designed to track a benchmark index. However, with the promulgation of the Securities and Exchange Commission's 2019 ETF Rule, funds are permitted the use of custom creation/redemption baskets. This change effectively enables a form of active basket management during the ETF's arbitrage process. In this paper, I show that the uptake of custom baskets has heterogeneous effects on the microstructure of corporate bond ETFs. While custom baskets enhance the liquidity transformation of bond ETFs, this comes at a cost, as they concurrently produce larger index tracking errors. To isolate these effects empirically, I exploit the 2019 ETF Rule as a quasi-natural experiment. My findings substantiate the presence of a trade-off between liquidity enhancement and tracking error minimization, and underscore the role of custom baskets as contributors to this trade-off.