In recent weeks, exchange-traded funds have been launched from every corner of the investment management industry.
Eagle Capital Management debuted a $1.9 billion ETF with assets from a separately managed account strategy. First Trust Advisors rolled four closed-end funds into one ETF. And Tremblant Capital recently converted an unregistered private fund to an ETF. But the ultimate spark for the next reshaping of the ETF market may lie in a nearly 25-year-old innovation more closely associated with traditional mutual funds.
Over the past 15 months, about a dozen asset managers have queued up at the U.S. Securities and Exchange Commission to offer multishare-class mutual funds that include ETFs.
Currently, the feature is only available through exemptive relief from certain aspects of the Investment Company Act of 1940. It was also explicitly excluded from the SEC’s 2019 ETF rule, which aimed to modernize the regulation of exchange-traded funds and allow them to launch without having to apply for individual exemptive relief.
That rule was groundbreaking for many asset managers and ETF issuers, but some believe it left chips on the table by excluding the share class feature.
The rule, known as 6c-11 for its place in the ’40 Act, standardized the process for launching and managing both index and active ETFs and required that they make daily disclosures of their full portfolio. It also smoothed the way for ETF conversions.
Through December, 32 issuers had flipped 71 mutual funds to ETFs with $70 billion in assets at the time of conversion, according to a February paper from law firm K&L Gates and investment firm Brown Brothers Harriman. Dimensional Fund Advisors, J.P. Morgan Asset Management and Fidelity Investments, for example, have each converted billion-dollar mutual funds to ETFs.
Such conversions may just be a way station on a longer journey to greater flexibility for investment product providers. Offering ETFs as a share class would remove the need for wholesale conversions. It could also allow one-way fund to ETF conversions at the preference of the investor.
Currently, the share class structure is only available for indexed products offered by Vanguard Group, which launched ETFs in 2000 and received a patent on the process in 2001.
The combination of the ETF rule and the expiration of Vanguard’s patent in May 2023 now has many issuers eyeing the share class opportunity.
In just the past few weeks, AllianceBernstein and Neuberger Berman have added their names to a list that already includes Dimensional, Fidelity and PGIM, among others. And, in early April, exchange company Cboe Global Markets filed an application with the SEC to allow the trading of ETF share classes on its Cboe BZX Exchange.
Unlike the process for approval of bitcoin ETFs, which took years of negotiations and, separately, a very visible lawsuit by one issuer, the tail winds behind the share class structure have made regulatory approval appear inevitable, believes Aisha Hunt, founder and CEO of NextGen Fund Consulting and principal at law firm Kelley Hunt.
“This hybrid fund model will resolve what a lot of investors are looking for,” Hunt said. “It will also compel issuers to reconsider how they think about products.”
The share class extension could also go in the opposite direction, said Hunt, giving “any multibillion-dollar ETF the ability to access 401(k) distribution.” Indeed, one of Hunt’s clients, F/m Investments, applied in August to offer mutual fund share classes of its existing U.S. Benchmark Series of indexed U.S. Treasury ETFs.
Hunt believes that narrow relief on a case-by-case basis for share classes could arrive within the year, while broader relief is slightly further out.
Todd Rosenbluth, head of research at VettaFi, said that the potential for share class relief ties directly to the interest in fully transparent actively managed ETFs. According to FactSet Research Systems data cited by Rosenbluth, active ETFs have received $73 billion (32%) of net flows to ETFs through April while representing just 7% of the $8.6 trillion in U.S. ETF assets under management.
“Active ETFs have had good traction and increased launches,” Rosenbluth said. “Supply will increase if share class relief is approved, allowing asset managers to bring existing track records, scale and distribution resources to the ETF.”
Both Hunt and Rosenbluth agree that share class relief could also help to simplify somewhat opaque and confusing platform fees. These fees, common for mutual funds on brokerage or 401(k) platforms, are also assessed in a more roundabout way through negotiated terms between some platforms and ETF providers.
This practice recently bubbled to the surface when Fidelity shared with clients that it was planning to assess a surcharge up to $100 on ETF buy orders for nine issuers that had not signed on to a revenue-based fee. Representatives for other brokers and asset managers were unavailable or chose not to comment.
Brokers argue that the fees, however assessed, support investments in data and technology to give ETF issuers better information about clients and activity on their platform. The fees are also a remnant of traditional mutual fund sales, as well as early “pay to play” no-trading fee ETF offerings.
“Support fees help maintain the technology and service operations needed to ensure a secure and positive experience for investors,” a spokesperson for Fidelity said. “We remain committed to providing clients choice with an open architecture investment platform.”
Representatives for other brokers and asset managers were unavailable or chose not to comment.
Housing ETFs and traditional mutual funds within the same investment company could also enhance the interoperability of taxable and non-taxable accounts, particularly for IRA and 401(k) investors. For example, a 401(k) mutual fund investment could be converted into its corresponding ETF share class when a participant chooses to leave a plan.
To be sure, there are still areas of the fund and ETF market that would be challenged by the share class model. Narrower and less liquid strategies, particularly those invested in concentrated portfolios of small-cap and non-U.S. equities or thinly traded fixed-income securities, remain difficult to square with the always-open ETF structure.
