By Robin Kaukonen, Sr. Portfolio Manager – Summit Global
As promised in last month’s “The Art and (Science) of Trading,” I plan to take you down the rabbit hole of ETF custom rebalances. But first, let’s take a step back and talk about the origins of ETFs and why they’ve become so ubiquitous in the world of investing today.
ETF History
The ETF story really began in the early 1990s. The first ETF to gain lasting traction in the United States was the SPDR S&P 500 ETF Trust (ticker: SPY), launched by State Street Global Advisors on January 22, 1993. It was designed to give investors a liquid, tradable proxy for the broad U.S. equity market. Historical records suggest initial assets were around $6.5 million at launch, growing to just under $500 million within the first couple of years. Today, SPY’s assets under management are approaching $600 billion.
Growth was gradual at first. By the mid-1990s, ETFs in aggregate still held only a few billion dollars in assets. But as indexing gained broader acceptance and markets matured, investor interest accelerated sharply. U.S. ETF assets crossed $1 trillion by 2010, and today the global ETF industry manages many trillions of dollars across thousands of products spanning equities, bonds, commodities, and alternative strategies.
ETF Basics
Most people are familiar with the basics: ETFs trade like stocks, offer diversification, and tend to be low-cost and tax-efficient.
What may not be as well known is that ETFs operate within two distinct markets: the secondary market and the primary market. Trading on the secondary market looks just like stock trading—on the NYSE, NASDAQ, and other exchanges. In the primary market, authorized participants (APs), typically large broker-dealers, create or redeem ETF shares directly with the fund sponsor.
It’s not necessary to know all the details of this process. What is important is that the create-and-redeem mechanism provides liquidity when trading an otherwise illiquid ETF. For example, if you want to buy 20,000 shares of an ETF where the average daily trading volume (ADV) is only 2,000 shares, you could end up paying significantly higher prices than your arrival price. In the primary market, however, an AP can create new shares and sell them to you at prices more in line with the bid-ask spread.
Custom Rebalances
Okay — are you ready for the rabbit hole of custom rebalances?
Summit Global Investments typically rebalances its ETFs monthly. But what if our models tell us to sell a position with a large gain? This is where custom rebalances come in.
Our trading team looks at the trading solution for the rebalanced portfolio and scrutinizes the positions, specifically the “sells.” The value of the sells with significant profits is quantified. Our Lead Market Maker (LMM) then creates ETF shares equal in value to those profitable sells. These creates include all the stocks in the portfolio.
Next, we turn around and redeem ETF shares corresponding to the high-gain positions, without realizing those gains. The net asset value of the fund remains the same because the creates and redeems are for equal amounts. Make sense?
If not, no worries. Just know that with ETFs, the goal is tax efficiency, and the create-and-redeem mechanism makes that possible.
Put another way: with ETFs, investment professionals can select which securities to redeem, enabling the strategic removal of highly appreciated positions. Mutual funds lack this flexibility because sales are driven by cash needs rather than tax optimization.
Conclusion
ETFs have been around since the early 1990s, and it’s safe to say they’re here to stay. Custom rebalances highlight the structural advantages of ETFs in modern portfolio management. Through precise timing, in-kind creations, and custom redemptions, ETFs can manage exposures, control P&L, and minimize taxes. As markets grow more complex and tax awareness becomes increasingly important, the flexibility and efficiency of ETFs — particularly in institutional and high-net-worth portfolios — continue to drive their dominance.
