How to Navigate the Hidden Frictions of ETFs

The asset management industry is undergoing a structural transformation. Exchange-traded funds (ETFs) continue to capture a growing share of investor flows, while traditional mutual funds face stagnation — and in many cases, decline. 

From 2020 to 2025, total investments in ETFs grew almost 150% from $8T to $19.5T. This divergence reflects a shift in what investors expect from their investment vehicles.

Today’s clients increasingly prioritize intraday liquidity, tax efficiency, and transparency. ETFs deliver on all three dimensions, making them an essential component of modern portfolios. 

Many institutional asset managers who have built their franchises on mutual funds are feeling mounting pressure to establish a credible ETF strategy. But if these firms assume that an ETF is just another wrapper for an existing strategy, they’ll be mistaken and ill-positioned to take advantage of the opportunity in front of them. Launching an ETF is much more than a product extension; it is an operating model transformation.

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Fundamental Differences Between ETFs and Mutual Funds

At a structural level, ETFs differ from mutual funds in ways that affect the entire organization. Mutual funds transact once per day at end-of-day net asset value and rely on cash subscriptions and redemptions. By contrast, ETFs trade intraday on exchanges, with primary market activity facilitated through in-kind creation and redemption processes managed by Authorized Participants (APs). This shift from cash to in-kind flows introduces new considerations for portfolio construction, trading, and tax management.

Transparency expectations further complicate the transition as most ETFs disclose holdings daily, instead of the periodic reporting typical of mutual funds. For active managers, this raises legitimate concerns around front-running and the protection of intellectual property. Strategies that operated comfortably within the relative opacity of mutual funds must now adapt to a world of continuous visibility.

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Operational Challenges of ETFs

While these structural differences are well understood in theory, their operational implications are often underestimated. That’s because ETFs introduce an entirely new ecosystem of participants, including Authorized Participants, market makers, and liquidity providers — all of whom play a critical role in ensuring efficient trading. Establishing and managing these relationships is central to product success.

At the same time, firms must develop new capabilities around basket construction and management. Creation and redemption baskets must be published daily, and balancing creation unit activity with active portfolio management decisions introduces new challenges. These workflows differ materially from traditional mutual fund operations and require tight coordination between portfolio managers, trading desks and operations teams.

Gain/loss management introduces a new challenge and opportunity for an ETF manager. An ETF can dispose of gains by exercising a custom basket process, which allows the manager to avoid these gains, but also comes with a new operational burden. Managers need to carefully monitor the value of the custom basket and balance that with standard basket creations and redemptions to ensure they are achieving their end goals.  

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How Technology Can Amplify These Challenges

Many legacy systems were not designed to handle the nuances of ETF operations, leaving firms with technology gaps that amplify these challenges. Portfolio accounting platforms must support in-kind transactions and these must be reflected to portfolio managers and traders immediately. Firms must also calculate and disseminate intraday indicative values (iNAV), publish daily basket files to the NSCC, and meet heightened expectations for real-time data accuracy and availability.

These demands force difficult decisions around vendors and platforms. Some firms opt for outsourcing solutions to accelerate time to market and reduce operational complexity. Others pursue full in-house builds to retain control and differentiation, accepting the higher upfront cost and longer implementation timelines. In either case, significant investment in infrastructure is unavoidable.

Yet even these operational and technological hurdles are not the most difficult part of the transition. The true barrier is organizational. An ETF provides new investment opportunities, but also comes with an overhead burden of providing standard baskets, managing transfers from creations and redemptions and relieving lots through custom basket processes.  

New roles are also essential. ETF capital markets specialists, product experts, and hybrid investment-distribution professionals become critical to bridging internal gaps and engaging effectively with external market participants. For many firms, building these capabilities represents uncharted territory.

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In-House vs. Outsourcing

Institutional managers considering entry into ETFs have several strategic paths. Outsourcing platforms offer a faster, lower-risk entry point, particularly for firms looking to test demand.  However these services come at a significant cost. Converting existing mutual funds into ETFs provides tax advantages and allows managers to retain assets while transitioning clients into a more efficient structure. Alternatively, firms can invest in building full in-house ETF capabilities, positioning themselves for long-term control and scalability.

Each path carries trade-offs, but all require a clear understanding of the underlying transformation involved.

Ultimately, ETFs represent a different way of delivering investment strategies — one that integrates distribution, liquidity, and market structure into the core of the product itself. Firms that approach ETFs as a simple extension of their mutual fund lineup risk underestimating both the complexity and the opportunity. The firms that succeed will be those that recognize ETFs as a business model shift. They will invest in capital markets capabilities, modernize their infrastructure, and align product, distribution, and operations around the demands of an exchange-traded ecosystem.

Ridgeline is working with customers to understand and address the challenges in managing ETFs. From standard basket notification to custom basket creation to intraday reflection of in-kind transfers, Ridgeline is creating solutions that are built for ETF Managers.  

Whether launching ETFs or growing AUM, Ridgeline welcomes a conversation about how to support your firm’s ambitions. Please reach out to us at hello@ridgeline.ai. 

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