What’s the Holdup on ETF Share Classes?

With cryptocurrency ETFs soaking up so much attention lately, it has been easy to overlook the other issue that was expected to be a big deal this year: the ETF mutual fund share class, which quietly hangs in limbo at the Securities and Exchange Commission.

At least three dozen mutual fund companies have filed for permission to create ETF shares of existing mutual funds and, considering the size and stature of the filing firms, smart money would suggest an SEC approval is in the making.

“Based on some of the discussions we’ve had with asset managers, they seem positive that it will go through,” said Daniel Sotiroff, senior analyst at Morningstar.

But don’t get too excited just yet, because as good as an ETF share class might be for investors for tax management purposes, approval puts the SEC in an odd spot with a government writ large that is hyper-focused on tax revenue.

No matter how it’s sold, the ultimate advantage of an ETF share class is that it functions as a mechanism for purging capital gains distributions from a mutual fund, which is certainly not lost on the SEC regardless of its mandate to protect investors.

ETF Share Classes Are Stuck at the SEC

The model that all those mutual fund companies are pursuing was created a few decades ago by The Vanguard Group, which has ETF share classes on most of its index mutual funds thanks to a patent and early SEC approval.

When Vanguard let that patent expire in May 2023, the filings to mimic the unique structure started piling up at the SEC, which has been mum on the topic since denying Vanguard’s request to extend the ETF share classes to actively managed mutual funds nine years ago.

Morningstar’s Sotiroff remains both somewhat confident an SEC approval is coming and somewhat perplexed that the SEC can let Vanguard stand as the lone provider of ETF share classes.

“It sort of sends the message the SEC, in retrospect, isn’t happy with the approval of the Vanguard structure,” he said.

In terms of the potential for lost tax revenue, which the SEC probably shouldn’t be applying as part of its evaluation calculations, Sotiroff said the steady flows out of mutual funds proves that revenue channel is eventually going away, regardless.

Citing the $510 billion that left mutual funds last year on top of another $300 billion worth of outflows through October this year, Sotiroff said the money is moving toward ETFs, mutual fund share classes or not.

It ultimately boils down to mutual fund issuers hoping to use ETF share classes to slow the outflows by making mutual funds a little more tax efficient. Time will tell, though, if that’s enough incentive for the SEC.