SEC ‘caution’ extends Vanguard’s ETF share class monopoly

More than nine months after Vanguard’s lucrative patent on using exchange traded funds as a share class of existing mutual funds expired, rival asset managers are still waiting for approval to copy the structure.

Guinness Atkinson, the first firm to convert a mutual fund to an ETF, is the latest to file for permission to add ETF share classes to its mutual funds. It is the sixth US asset manager to do so, joining Morgan Stanley, PGIA (the US division of Australia’s Perpetual), Dimensional Fund Advisors, Fidelity and First Trust. Meanwhile, F/m Investments has filed to launch mutual fund share classes of its ETFs, bringing to seven the total filing for a multi-share class structure.

T Rowe Price and JPMorgan say they have also been looking into using such a structure, which could allow them to more easily expand their mutual fund strategies into the more popular ETF wrapper.

But Securities and Exchange Commission concerns about potential conflicts of interest between the mutual fund and ETF share classes and a busy rulemaking agenda were combining to extend the wait for a decision, experts said.

“The benefits are certainly of interest to asset managers, but the SEC, I think, will take a very cautious approach in terms of approval,” said Tim Huver, managing director on the US ETF services team at Brown Brothers Harriman.

The ability to launch ETFs as share classes of existing mutual funds and to enjoy the economies of scale that come with the structure has been around for more than two decades — but only for Vanguard, which secured a patent giving it sole rights to use the dual-class structure in the US from 2000 to 2023.

The structure has helped power the $9tn asset manager into a position where it is chipping away at BlackRock’s dominance in the ETF industry, with its multi-share class funds amassing more than $5tn in assets combined.

Structuring a fund with multiple share classes allows managers to expand their ETF franchises without new launches, with an existing record (which can be essential if the intention is to attract institutional investors) and it also preserves assets in existing mutual funds.

It means that managers can continue to offer mutual funds to users of retirement schemes such as 401(k) plans, which give equal tax status to ETFs and mutual funds. Outside 401(k) schemes, however, ETFs have consistently outstripped the mutual fund for net new assets: the former pulled in about $2tn from 2021 through 2023, while the latter shed about $1tn, according to Morningstar Direct.

Asset managers such as Dimensional Fund Advisors — which has a fast-growing ETF business but still runs most of its assets under management in mutual funds — think it has made “a very thoughtful case” for why the SEC should allow other firms to launch ETF share classes of mutual funds, said Rob Harvey, co-head of product specialists at Dimensional.

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But he acknowledged that the SEC has been “very transparent about their agenda” and that ETFs as a share class “just hasn’t been present on that list”.

Since allowing Vanguard to move ahead with ETF share classes, the SEC had expressed concerns related to the different share creation and redemption mechanisms of mutual funds and ETFs, said Jeremy Senderowicz, an attorney with law firm Vedder Price.

Mutual funds have to sell shares if they face redemptions, or buy shares with cash if people wish to invest, while ETFs can use in-kind transactions to deliver a basket of securities in lieu of cash. Those different types of transactions are treated differently from a capital gains tax point of view, and ETF class shareholders may have to help shoulder trading costs incurred by mutual fund classes.

The SEC did not respond to requests for comment.

Meanwhile, managers that want to expand more into ETFs are preparing to lean into the dual share class structure if the opportunity arises.

“As the industry is developing right now, we are staying very close to that conversation,” said Bryon Lake, JPMorgan Asset Management’s global head of ETF solutions. “We’ve got some of our brightest minds . . . thinking about that project right now.”