It’s no secret that exchange-traded funds (ETFs) have taken the investment world by storm. Assets in both passive and active ETFs have surged to trillions of dollars globally as investors have discovered the vehicle’s benefits, including lower costs, intraday tradability, and the potential to reduce taxes.
The best part is the growth of ETFs could be just getting started.
That’s because this year could see the expansion of dual share class listings of already existing mutual funds. Thanks to a key patent expiration a few years ago, the ability of existing mutual funds to use ETFs as a share class are now set to start occurring across the board. With trillions in mutual fund assets, this could be a huge tailwind to ETF adoption and growth.
Vanguard’s Secret Weapon
Malvern, Pennsylvania may not seem like a hotbed of innovation. But for the financial industry, it is. Malvern happens to be the home of Vanguard. After creating the index fund, Vanguard used its acumen to change the ETF landscape back in 2001.
Vanguard developed a patent that allows them to classify their ETFs as a share class of their mutual funds. The significance of that patent is great.
If you remember, the win of ETFs is their dual market structure. The bulk of investors buy ETFs on the secondary market. However, authorized participants—such as institutional investors, endowments, and investment banks—can buy ETFs on the primary market. Here, these APs exchange cash or enough securities to ‘make’ a share of an ETF, which then gets placed on the secondary market.
The beauty is this process works in reverse. When an AP goes to sell, they can receive shares in-kind. This is why ETFs are more tax-efficient than mutual funds.
The win for Vanguard is that its patent allows its mutual funds to use the in-kind creation/redemption mechanism to reduce taxes. For example, the Vanguard 500 Index Fund (VFIAX) hasn’t paid a single capital gain since 2001 when the patent was created, as its managers can use the ETF version, aka Vanguard S&P 500 ETF (VOO), for authorized participants to receive the stock.
This provided Vanguard with a huge edge in gathering assets, reducing costs for investors, and helping it dominate ETF league tables.
The Patent Expires
The thing is patents and trademarks expire after a while. The same was said for Vanguard’s ETF share class patent. Back in the spring of 2023, the investment manager lost the exclusive right to use the dual share class ability.
And now we could be off to the races.
Since the patent expiration, dozens of asset managers—some without ETF businesses—have now filed with the SEC to start offering dual share classes of their existing mutual funds. This includes big names like Morgan Stanely, Fidelity, Dimensional, First Trust, and BlackRock.
This is significant because, according to the Investment Company (ICI), there was more than $25.5 trillion worth of assets in traditional mutual funds at the end of 2023. Last year’s numbers are not out yet. This pie chart shows how mutual funds still dominate the conversation even versus ETFs. 1
Source: ICI
Now, there have been some regulatory hurdles and pauses from the SEC. The agency has voiced concerns the dual share class listings could create potential conflicts of interest between the mutual fund and ETF share classes. Additionally, fee structure concerns and differences in potential voting rights have been expressed by the agency.
However, with the SEC already greenlighting Vanguard in 2001, and with the success, lower taxes, and smooth-running ability of these funds, many pundits believe the SEC doesn’t have a leg to stand on. Moreover, the pro-business and friendlier Trump Administration’s SEC is more likely to approve these relief filings to use the expired patent.
With this in mind, dual share listings could be the story of the year about ETFs and we could finally see the floodgates open for investors.
A Big Net Positive
If—and it’s most likely -when the SEC decides to allow dual share classes, it could be game time for portfolios and investors of all stripes/sizes. As we see, there are trillions of dollars in assets tied to mutual funds that could instantly become ETFs. From an asset management point of view, this is huge. Those legacy managers who have been slow to embrace ETFs could save themselves from outflows and give themselves a new life. For those firms already leading within the ETF ecosphere, additional asset gathering and boosting their placement in league tables is assured.
Perhaps the biggest win would be investors on several fronts.
For starters, there are costs to consider. ETFs are generally lower cost than mutual funds. However, in the case of Vanguard, the fact there is an ETF share class is one of the reasons why the overall costs of its funds have continued to drop. There are fee pressures even within a fund itself. This is great news for investors who stick with the mutual fund share class such as those within a 401k or other retirement vehicle.
Second, there’s tax efficiency to consider. As we’ve highlighted, with ETFs as a share class, investors in the mutual funds are now able to realize lower capital gains taxes.
Finally, there could be better returns and less cash drag. One issue with mutual funds is that asset managers can’t be fully invested. They need to always have a layer of cash in their funds to support investor redemptions or sales. If they don’t, they could be forced to sell assets before they want to. This creates a ‘drag’ on a fund’s returns. ETFs avoid this due to their creation/redemption mechanism and. with the ETF as a share class, managers can now be fully invested, reducing this hindrance on returns.
All of this is great news for investors. No matter what structure you choose for a fund—ETF or mutual fund—investors can gain valuable benefits for their portfolios and are able to meet goals that much easier.
And now, with the SEC potentially greenlighting dual share classes, the dream of Vanguard’s patent could be coming to all portfolios.
The Bottom Line
The hottest story this year could be the dual share class listings of ETFs and mutual funds. This could provide a huge surge of new ETF assets, as well as provide investors with plenty of benefits. Arguably, it could be the biggest trend since ETFs were created in the first place.
1 ICI ( January 2024). 2024 Fact Book
