Firms Back Effort to Carve ETF Shares from Mutual Funds

ETF issuers are getting behind an effort to create exchange-traded funds from existing mutual funds, in hopes the move will upend decades of standard process and pull billions of dollars into the industry.

Firms from Dimensional Fund Advisors to Morgan Stanley, as well as First Trust Advisors, Fidelity Inc. and most recently this week Guinness Atkinson, are seeking exemptions from the Securities and Exchange Commission to roll out ETF share classes of already existing mutual funds. If the exemption is granted, firms could issue ETFs as a share class of a previously existing mutual fund, allowing mutual funds to gain the tax efficiency of an ETF.

The unique structure was previously exclusively available to asset management behemoth Vanguard. The SEC gave Vanguard exemptive relief from regulations in the Investment Company Act of 1940 in 2000, which then allowed the firm to issue ETF shares of its already existing mutual fund. The firm was the only one to use that structure from when they patented it in 2003 to when that patent expired last May.

The U.S. ETF industry's assets have surged to $11.6 trillion in part by pulling money from traditional mutual funds, which have been shedding assets over the past few years. Exchange-traded funds have proven to be a more nimble investment than mutual funds, with tax and other advantages over their older cousins. Cerulli Associates in September said the mutual fund industry's assets had shrunk to $17 trillion.

Yet the SEC may not be willing to grant the relief again. Many see the move as forcing ETF investors to subsidize mutual fund investors, by making ETF customers pay the higher capital gains associated with mutual funds, according to director of passive strategies research at Morningstar Bryan Armour.

“It’s a complicated issue for the SEC,” said Armour. He said the ease at which ETFs can be traded compared with mutual funds, along with their different tax structures, may make it hard for the SEC to legislate a new share class that would benefit ETF and mutual fund shareholders equally.

Regulatory Saga

Ben Slavin, Global Head of ETFs at BNY Mellon, told etf.com at the ETF Exchange Conference in Miami that exemptive relief was a key issue he was discussing with clients in the firm’s asset servicing business, and added he saw it was a “when, not if” in terms of the SEC eventually approving the vehicles. 

Yet not everyone is as optimistic. “For the ETF share class, we are evaluating that space, but it’s not immediately obvious to me that it’s going to get approved, it’s also not immediately obvious to me that is changes something substantially,” said Bryon Lake, Head of ETF Solutions at J.P. Morgan Asset Management in an interview at the ETF Exchange Conference with etf.com.

Issuers emphasized that they see this as a long-term regulatory process. Armour gave the odds of eventual approval a 50/50 chance. There is no deadline for the SEC to make a decision.

One significant benefit of having ETF share classes instead of mutual fund to ETF conversions or simply launching a copycat mutual fund strategy in an ETF structure, is that ETF share classes could be a part of mutual funds that already exist in 401k retirement strategies. Currently, 401ks are not able to hold ETFs.

“I think by far the biggest advantage for the asset managers is the fact that adding on an ETF share class allows them to maintain their funds that exist in retirement plans, while also adding the ETF to the strategy,” said Armour.

More applications for the exemptive relief are undoubtedly coming, analysts and executives say. If the structure is approved for one or more firms, a flood of issuers may rush to issue the conversion. Still, issuers expect a drawn-out regulatory process.

Another option issuers are utilizing is to convert mutual funds into ETF, a move many firms, including Franklin Templeton and Dimensional, are already implementing.

Contact Lucy Brewster at [email protected]