As the Exchange Traded Fund (ETF) industry continues to proliferate, it is time for asset managers to look across their ETF operating model spectrum and consider their options for insourcing, outsourcing or hybrid models.

In comparison to mutual funds, the processes across the ETF operating model are unique and more complex, which leads many new ETF sponsors to initially utilize an outsourced model for core investment operations. As the book of business expands and matures, the opportunities to leverage hybrid and insourced models could increase.

Asset managers have four key components to the various operating models they use to support their ETFs: Basket creation, basket processing, trading and order taking, and collateral management and settlement. Historically, standard industry practice has dictated the following approach to insourcing versus outsourcing each function:

  • Basket Creation: Typically completed in-house by portfolio managers who want control over the flow of securities into the fund (create basket) and out of the fund (redeem basket). Smaller, start-up ETFs tend to have the service provider create the basket using predefined rules.
  • Basket Processing: Commonly outsourced due to the operational complexity of the required Trade Day (T-1) accounting projections and the processing required to estimate the cash amount.
  • Trading and Order Taking: Historically this function was outsourced, but that has been changing. Over time, more firms have been building out trading desk capabilities to support their ETFs, however many industry players are still continuing to use a third party’s order-taking platform.
  • Collateral Management and Settlement: Most often outsourced to keep the process close to the custodian.

Finding the appropriate ETF operating model depends on a number of factors including domain expertise, technology capabilities, and business requirements. The insource-outsource spectrum has five basic models ranging from full outsource to full insource:

Full Outsource Model: For start-up managers, new ETF sponsors, or those seeking a simplified model, a fully outsourced operating model provides a near turnkey platform. This model capitalizes on the service provider’s expertise and industry proven solution.

Capital Markets Model: A variation of the full outsourcing model, where ETF sponsors take responsibility
for the trading of their products themselves.

Product Ownership Model: As the ETF sponsors gain increased comfort, experience, and capabilities, they may want to take control of the basket creation function to help reduce risk, or if they wish to pursue an active investment strategy.

Product and Trading Model: For larger sponsors with more funds, the operating model may need to support an order-taking platform to capture custom order requests.

Full Insource Model: Experienced ETF sponsors with the size, scale, and resources may look to insource all functions they can perform themselves.

The most efficient service models are able to minimize handoffs, eliminate manual processing, and utilize a strong control environment while being supported by associates with expertise and experience in ETF operations. The shape and design of this optimal service model should grow and evolve as an ETF business matures to one of increasing size and scale.

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