Vanguard entered the exchange-traded fund market in 2001 with what seemed like an unquestionable edge: an exclusive patent that allowed it to launch ETFs as additional share classes of its existing index mutual funds.
It’s hard to overstate how revolutionary that was. It made launching a new ETF as easy as launching another share class of a standard mutual fund. Not only that, the move gave Vanguard the ability to spread at least some of the tax and cost efficiencies of the ETF structure to its mutual funds.
More than 20 years later, that patent is set to expire in May. The U.S. arm of Australia’s Perpetual Group has already filed to roll out ETF share classes for its actively managed mutual funds.
Indeed, this capability has been the envy of other U.S. issuers for some time.
"There has been interest in this structure for really as long as I can remember,” said Stacy Fuller, a partner in Pittsburgh-based K&L Gates’ asset management and investment practice group.
Brian McCabe, a partner specializing in asset management issues at Boston law firm Ropes & Gray, says that while he has seen demand from issuers, he isn’t sure there’s currently equal demand from investors. That, he said, might be due to a lack of familiarity with the intricacies of how such a product would work.
A Possible Wrinkle
The words “actively managed” are what may be a fly in the ointment for Perpetual. Vanguard’s patent has been used solely with its passively managed index funds. The SEC is yet to approve the ETF share class structure for actively managed funds. As a result, the question remains as to whether launching an ETF share class of an actively managed mutual fund is even possible.
Daniel Sotiroff, a senior manager research analyst with Morningstar Research Services, is not sure where the SEC stands on the issue, noting that, rather than wait for the patent to expire, other active managers such as Capital Group have simply launched their own stand-alone ETFs.
“There’s kind of a signal there that maybe the SEC is not 100% on board with this,” he suggested. Sotiroff published an analysis of the Vanguard patent situation last month.
Another glaring question is, why would an issuer want to do it?
As revolutionary as the Vanguard design was at the time of its first implementation, current-day issuers considering it have more than a few things to think about, especially if they’re active managers. Just like converting a mutual fund into an ETF, adding a share class could come with a raft of both benefits and drawbacks.
At first glance, Vanguard’s patented structure seems like a win all around. After all, with Vanguard implementing it, the firm’s ETF investors could access Vanguard strategies and low costs via their preferred wrapper, while its mutual fund investors benefited from the tax efficiencies of the ETF share class, which allowed the overall fund to swap out low-cost basis shares for high-cost basis shares.
Essentially, the ETF share class helps Vanguard keep its capital gains distributions low for all of a fund’s associated share classes.
But that also means that the mutual fund share classes can ding the tax efficiency of the ETF share class if their capital gains distributions are too great to be swapped out via in-kind redemptions.
“You would ideally want [a mutual fund] that has some tax loss carry-forwards on its books,” Sotiroff said. “That way, when you bolt the ETF [share class] on, the ETF is not instantly exposed to potential cap gains, and it has some time to gain some critical mass to where it can actually just—through its regular trading activity—have the ability to purge capital gains.”
However, McCabe believes situations in which mutual funds negatively affect the ETF shares of a fund would be fairly rare, and could generally be avoided with careful management.
“If you're paying attention and tracking the right securities, you wouldn't need much inflow or outflow on the ETF side to reduce the unrealized capital gains of the fund as a whole," he said.
There’s also the problem of closing to new investments.
Mutual funds can stop accepting investor dollars if the managers feel the fund has gotten so big that its size is interfering with its investment goals. The question gets cloudier with the ETF structure, where McCabe says there is limited guidance from the SEC on whether ETFs can close to new investments. He notes that it was only in 2019’s ETF Rule, 6c-11, that the SEC staff mentioned that ETFs must ordinarily accept new purchase orders.
The wish to stop issuing new shares is unlikely to be a big problem for index strategies that cover major asset classes, but could present an issue for actively managed funds taking high conviction bets, possibly in smaller-cap securities.
“Ideally, you want something that doesn't have capacity concerns in the future—the more broadly diversified stuff that maybe is taking some modest active risk around the edges would probably be the best candidates there,” Sotiroff added, suggesting that active issuers like Dimensional Fund Advisors and Avantis might have the best investment style suitable for an added-on ETF share class, because they tend to invest in broad asset classes rather than focusing on stock picking.
Sotiroff also raises the issue of fee structure, noting that costs like front-end loads or 12b-1 fees are not the norm when it comes to ETFs. “I would think you would want a mutual fund that doesn't have either of those attached to it,” he commented.
Benefits to ETF Investors?
Ultimately, the benefits of adding a bolted-on ETF share class seem skewed toward the mutual fund class shareholders.
“The main benefactor here is really the existing mutual fund investors, because they inherit that tax efficiency of the ETF structure that comes on board,” said Sotiroff, though he suggests the mutual fund’s existing asset base might provide some insurance to ETF share class investors regarding the fund’s viability going forward.
Sotiroff urges investors to do their due diligence if other firms adopt the ETF share class structure for their existing mutual funds, highlighting the importance of a fund having sufficient capacity and tax-loss carry-forwards.
“I would be a lot more diligent if I were looking to get into one of these newer ETF share classes than if I were an existing mutual fund shareholder,” he said.
That said, both Fuller and McCabe see benefits for ETF investors as well.
Fuller cites ETFs’ need for seed capital when they are newly launched as stand-alone products, something that could be avoided by being an additional share class of an established fund. Similarly, McCabe cites the fixed expenses associated with running a fund, and notes that economies of scale would allow a fund with an additional ETF share class to spread those costs out even more.
Contact Heather Bell at [email protected]