Vanguard pioneered and began patenting this dual-share structure more than two decades ago, which helped its funds generate higher after-tax returns and capture almost a third of the U.S. market for ETFs. The last of its patents expired in May, providing firms such as Fidelity with an easier way to package their stock- and bond-picking strategies into ETFs.
"Fidelity's mainstay has been active management, and until this point in time, it has been very difficult to get ETFs around active funds," said Gus Sauter, who co-invented Vanguard's patent while serving as its chief investment officer. "I think Fidelity is looking at this as an opportunity to get into the space in a big way."
A Fidelity spokesperson declined to comment.
The dual-share class structure gives mutual funds access to the tax advantages of ETFs, boosting after-tax returns.
Distinct tax treatments have historically separated the ETF and mutual fund categories, with the former able to avoid capital-gains levies via its unique in-kind redemption process. Vanguard, by creating ETF classes for some of its traditional products, has used the design — entirely legally — to slash the taxes reported by its funds for more than 20 years.
Fidelity said in its application that portfolio managers who oversee dual-class funds could engage in "careful tax management."
When U.S. regulators introduced sweeping rule changes in 2019 to make launching ETFs easier, the U.S. Securities and Exchange Commission deliberately retained the need for issuers to apply for an exemption if they wanted to pursue ETFs in a multiple-share class structure.
With the expiration of Vanguard's patent, several other money managers have applied for such an exemption, including the U.S. arm of Australian asset manager Perpetual and Dimensional Fund Advisors, the quant firm co-founded by David Booth.
Vanguard's patent expiration removed one barrier for rivals. But there's no guarantee of getting clearance from the SEC, which has expressed concerns about conflicts of interest between mutual fund and ETF investors. Vanguard only received the clearance to apply the structure to index funds. Its filing to use ETF share classes in active strategies failed to get approval from the SEC.
The SEC clearance for Vanguard helped give the Malvern, Pennsylvania, fund a two-decade head start on building market share in the ETF industry. Fidelity alluded to this advantage in its application.
"Vanguard has become one of the major sponsors of index-based ETFs, with more than $2 trillion in assets invested through exchange-traded classes, representing almost 30% of all ETF assets in the United States," Fidelity said.
Fidelity in comparison has about $36 billion in ETF assets, representing a 0.5% market share, according to data compiled by Bloomberg Intelligence. That included about $8 billion of assets in actively managed ETFs.
Both Fidelity's ETF access and its market share will likely go up in the next 10 years, according to Eric Balchunas, a senior ETF analyst at Bloomberg Intelligence.
"Fidelity is ready to make some big moves," Balchunas said, adding that its application "doesn't surprise me."