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Vanguard's Patent About to Expire: What's Next for Active ETFs?

More than 20 years ago, when the ETF industry was still in its adolescence, Vanguard executives had a brilliant idea. Instead of introducing ETFs as independent investment vehicles, they developed and patented a method to incorporate them into mutual funds. That way, investors with short time horizons could buy and sell an ETF share rather than deal with the complexity of a mutual fund share.

After it became clear ETFs were here to stay, some competitors launched ETF versions of their mutual fund strategies. But these clones don’t carry over performance records and also risk cannibalizing higher-fee mutual funds.

Others began converting their mutual funds into ETFs. While this process preserves managers’ track records, it requires shareholder approval and the completion of merger agreements. As a result, they can be a costly and complex endeavor for any asset management firm.

By comparison, introducing an ETF within a mutual fund is straightforward and only requires exemptive relief from the SEC. And it provides a clear advantage to shareholders without necessarily cannibalizing its mutual fund shares. The only problem was Vanguard owned the patent.

But Vanguard’s patent expires in May 2023, and the strategy will soon be open to any asset manager.

See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.

A New Alternative?

Introducing an ETF as a mutual fund share class conveys numerous benefits. For instance, ETFs trade freely on stock exchanges, making them cheaper and more accessible.

There’s also a tax advantage. ETFs use an in-kind redemption mechanism to dispose of stocks and bonds with built-up capital gains. As part of a mutual fund, these ETF capabilities extend to stocks and bonds held by mutual fund share classes, making them more tax-efficient. As a result, few of Vanguard’s funds with ETFs distribute capital gains.

These unique advantages have already piqued the interest of at least one asset management firm. In February 2023, Perpetual U.S. Services proposed adding an ETF share class to its seven Barrow Hanley-branded, actively-managed funds.

However, there are a couple of drawbacks.

The Vanguard Extended Duration Treasury Index (VEDTX) illustrated one such drawback. In 2009, the fund had a capital gains distribution amounting to around 14% of the ETF’s year-end net asset value. That happened due to the appreciation in Treasury prices during the financial crisis and a lack of ETF inflows necessary to purge capital gains.

While Vanguard’s funds are passive, active ETFs could introduce another significant drawback. Many active mutual funds close the door to new investors if they run out of ideas to preserve their track records. But with an ETF, there’s no mechanism to prevent new money from entering, which could force managers to invest in less-than-perfect ideas.

It’s No Guarantee

The SEC is notorious for changing its mind. While the agency provided Vanguard with exemptive relief, there’s no guarantee that it will do the same for future asset managers, especially actively-managed funds.

The VEDTX debacle has already given the agency pause. For example, in 2019, the SEC raised concerns about potential conflicts of interest among investors in a fund’s share classes under the scheme. In essence, they argued that mutual funds and ETFs sell shares differently, resulting in different costs that all shareholders must bear equally.

If the SEC were to deny future asset managers access to the strategy, it wouldn’t be the first time the agency changed its mind. The SEC granted exemptive relief to three fund sponsors to issue leveraged and inverse ETFs, but its subsequent moratorium lasted at least a decade.

The Bottom Line

Vanguard’s patent on adding an ETF share class to mutual funds will expire in May 2023, and at least one asset manager wants to leverage the new vehicle in the active management space. However, it’s unclear whether other asset managers will get the same exemptive relief from the SEC that Vanguard secured, particularly in active funds.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.

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Mar 27, 2023