In the fall of 2019, the U.S. Securities and Exchange Commission finalized its long-awaited exchange-traded funds rule, easing the path to market for hundreds of new ETFs.
The rule, however, put a doorstop on the patented way that only Vanguard Group offered most of its index ETFs, as a share class of a traditional open-end mutual fund. Now, with Vanguard's patent having expired in May, other asset managers have filed regulatory paperwork to join the fray.
In February, Perpetual Asset Management (Americas) submitted an application with the SEC to issue ETF shares of existing actively managed mutual funds. Dimensional Fund Advisors followed with an application of its own in July.
"We're looking to realize the economies of scale that multiple share classes could bring for both mutual fund and new ETF shareholders," said Gerard O'Reilly, co-CEO and chief investment officer at Dimensional. As of June 30, Dimensional's traditional fund assets were $377 billion, according to Morningstar.
Yet, in less than three years from Dimensional's first offering, ETF assets under management grew to $93 billion through a combination of conversions and new issuance made possible by the ETF rule.
Referred to as "6c-11" for its place within the Investment Company Act of 1940, the ETF rule was designed to streamline the process for bringing both indexed and active ETFs to market, stipulating daily transparency of their investment portfolios. It also allowed for the use of "custom baskets" for the creation and redemption of ETF shares, which had only been available to a handful of issuers. And the rule went out of its way to mention that offering ETFs as a share class was not within scope.
The original Vanguard patent application in 2001 said that the intention of an ETF share class was to reduce duplication of efforts and minimize costs. But the most salient point in the patent has also become the most controversial. It states that the exchange-traded shares could select the "lowest cost lots of each stock distributed" for in-kind redemptions, reducing the unrealized capital gains.
Vanguard and others have utilized ETFs to effect "heartbeat trades," a term coined in 2017 by Elisabeth Kashner, vice president and director of global funds research and analytics for FactSet Research Systems Inc. Outside of standard redemptions, custom baskets can help to eliminate the shares of companies being acquired or moving out of an index. This activity reduces unrealized capital gains as a benefit to all fund shareholders, not just the ETF share class.
In a January article in The University of Chicago Business Law Review, "Unplugging Heartbeat Trades and Reforming the Taxation of ETFs," Fordham University Professor of Law Jeffrey M. Colon called for reform of what many see as an exploitation of favorable treatment for in-kind redemptions.
The "benefit" can also go the other way. In 2009, Vanguard's ETF share class of its Extended Duration Treasury fund distributed capital gains that amounted to 14% of its year-end net asset value. Such a distribution was due to modest flows to the ETF and "considerable outflows" to the institutional share class, according to a February Morningstar article.
Share class dabbling is not new. In March 2012, Van Eck Associates Corp. filed to offer ETF share classes for active or passive funds. In March 2014, Vanguard's first application for actively managed ETFs included the offering of ETF share classes. In April 2015, USAA Asset Management also took a swing at active. All were eventually dropped, and Vanguard filed a new application for active relief in late 2016, without the share class stipulation.
"The patent may not have been the obstacle for funds that wanted to introduce ETF classes," said Michael Mundt, a partner at Stradley Ronon Stevens & Young LLP. Mr. Mundt joined Stradley in 2011 after 14 years at the SEC where he worked on ETF policy. He and his firm represent Dimensional funds and the independent directors of the boards of the Dimensional funds.
Of Vanguard's 76 index ETFs, all but are six issued as an ETF share class. A Vanguard spokesperson said that "the multiple share class structure has provided enduring benefits to investors for more than two decades."
Ryan Jackson, a manager research analyst at Morningstar, referred to the functionality as a "garbage disposal for capital gains" that may only be "moderately positive" for all share classes. Still, Mr. Jackson thinks that the ongoing dialogue may not be giving the ETF structure enough credibility as the collective investment vehicle of choice, active or passive.
For the three years ended June 30, actively managed ETFs in the U.S. have experienced positive net flows of $255 billion. Traditional active funds, on the other hand, saw negative net flows of $1 trillion, according to Morningstar. For its part, Dimensional received $48 billion of the ETF flows (not counting conversions) and saw $73 billion leave its traditional funds.
