ETF Share Classes: Boon or Bust for $11T ETF Industry?
- The SEC is reviewing applications that would permit the creation of ETFs from mutual funds.
- The concern is that the share classes would strip ETFs of tax benefits that have led to their success.
- JPMorgan has said the SEC review includes examining potential downsides.
The great success of exchange-traded funds is due in part to investors getting the benefits of mutual funds—exposure to large swaths of stock, bond and commodity markets, for example—with less of the tax burden.
But experts are now sounding the alarm that some of those tax benefits may be at risk thanks to rule changes under debate at the Securities and Exchange Commission.
Dozens of companies are seeking the approval of rules that would permit the creation of ETFs from mutual funds—so-called ETF share classes. Some say that approval may diminish that same benefit that has led to the explosion of the $10.9 trillion U.S. ETF industry.
Washington, D.C., law firm Stradley Ronon says 59 companies have applied for the exemptive relief. SEC Commissioner Mark Uyeda is pushing for a rapid review of those applications from asset managers including BlackRock Inc. (BLK) and Morgan Stanley (MS), which have piled up over the past few years
To be sure, ETFs will retain benefits over mutual funds, like ease of trading and lower costs. At the same time, mutual fund issuers may find a new way to expand their market share that’s been reduced by the growth of ETFs.
ETF Share Classes, Mutual Funds and Capital Gains
One question for investors and issuers is whether or not ETFs' big benefit of efficient tax management gets lost in the share class process.
ETFs generally create fewer tax liabilities than mutual funds. Their structure minimizes taxes by not exposing the ETF holder to capital gains when a stock or bond in the fund is sold.
Share class rules may end up passing those capital gains expenses to holders of the new funds.
“Share class ETFs may not enjoy the same tax benefits as other ETFs,” JPMorgan Chase & Co. wrote in a report earlier this month. The report noted that while a handful of nations are considering ETF share class rules, the SEC is considering a “mechanism to reduce capital gains tax by transacting securities in-kind.”
Still, those episodes may be limited and rare, Nate Geraci, president of the ETF Store, explained during Wednesday's ETF Pulse podcast.
"Let’s say there are significant outflows from the mutual fund share class, or they have to sell positions, and the ETF can’t wash all of those through. That can be a negative for ETF investors where they actually get hit with a tax bill," Geraci said, adding that he thinks such a situation would be rare and it's something the SEC is considering as part of the lengthy evaluation process.
In the end, he said, "I view this as a positive for investors; there will be more choice."