In 2019, the Securities and Exchange Commission approved several applications for nontransparent active exchange traded funds. Then, the ETF industry hit another milestone in March 2021 when Guinness Atkinson Asset Management became the first to convert its mutual funds into ETFs, setting off a wave of conversions. But a new development could clear the path even further for mutual fund managers to get into the ETF space.
Last week, Perpetual US Services (PGIA) became the first to file an exemptive application with the SEC to establish an ETF multishare class structure for its mutual funds. To be sure, Vanguard has been using a similar structure since the early 2000s for passive funds, but the fund giant’s patent on the structure expires in May 2023. Perpetual’s filing is slightly different; for one, it’s for active strategies.
“The goal is to make the benefits of what is already available in having ETFs as a share class, making it available across a broader group of strategies, across a broader type of strategies, meaning active, more providers like that,” said Rob Kenyon, PGIA's chief operating officer. “It just broadens the investment opportunity, and it also improves the way in which investors can elect a mutual fund or ETF.”
Just becoming an ETF doesn’t necessarily guarantee success, Kenyon said. In fact, a recent Bloomberg analysis found that more than one-third of converted funds have seen net outflows in assets since making the switch, and 61% have attracted less than $10 million each.
Many fund managers have been holding out on converting their funds to ETFs because of some of the challenges of doing so, and this new structure could solve for a lot of the problems, including the need for a brokerage account to hold ETF shares, the fact the tax-efficiency benefits aren’t present in defined contribution plans, such as 401(k)s and the ability to close down a mutual fund to new purchases.
“If they can get this approved, I think it’ll have a huge uptake by other asset management firms in terms of wanting to go this route instead of dealing with the hassle of conversion,” said Neil Bathon, founder and partner at FUSE Research Network.
This structure also allows mutual fund managers to keep their investors and track records in place.
“The ETF structure doesn’t give you an advantage over mutual fund in the first three years, because you still need to build your track record, and have $100 million or $150 million in assets,” Bathon said. “It doesn’t necessarily make it easier. The same core requirements of success, or platform access even, are still in place.”
Bathon also believes this would help from a distribution standpoint, because the share class wouldn’t necessarily have to go through a review or approval process to get onto a platform at a brokerage firm, for instance. It would simply involve bolting on a new share class.
Douglas Yones, head of exchange traded products at the NYSE, said this would be a game changer for a lot of asset managers, if approved.
“The asset managers who, historically, maybe have not considered ETFs or considered a conversion, this would allow them to enter the ETF space very quickly with size and scale and the ability to offer their investment suite to ETF investors, which will just probably amplify the rate of growth of ETFs even further than it is today,” he said.
But Dave Nadig, ETF expert and financial futurist at VettaFi, said while this could be great for the ETF industry, he’s skeptical the SEC would approve the structure and that there are technical issues that have to be worked out.
“Essentially no exemption relief that gets issued in the modern world looks anything like the stuff that was getting approved at the turn of the century,” Nadig said. “The filer here is going to have to go through the same old process convincing the SEC to let them do this that they would if they were trying to do anything else, like launch a bitcoin ETF or anything else that was innovative. We have a pretty anti-innovation SEC right now. I would be extremely surprised if this got any kind of fast-track approval.”
Another issue Nadig points to is who benefits versus who gets harmed from these programs. Vanguard’s ETF share classes see one-way flow, allowing them to accumulate tax loss overhead, which is beneficial to shareholders across the entirety of the fund.
Vanguard’s Total Stock Market strategy was the first to use the approach; as a result, the mutual fund has distributed no capital gains to investors since 2001.
“That’s great. Nobody’s getting hurt. Everybody’s getting a benefit. There’s no reason to believe that that’s exactly what would happen if you just launch a new share class on a big existing mutual fund right now. It’s not like a magical, tax get-out-jail-free card,” Nadig said.
For that to work, you have to have the path dependency of redemptions kicking off those capital losses.
“I think there’s an argument to be made at the SEC that this isn’t necessarily beneficial to the existing mutual fund shareholders, if you end up in a world where one class of shares is redeeming, and the other one isn’t and you end up with capital gains that you have to distribute between the two,” Nadig said.
Potential class subsidization represents another challenge to getting the structure approved, Kenyon said. The regulator wants to make sure there isn’t a subsidy being applied to one share class as a result of the other.
“There is a sense that if the pool only costs x dollars to run, what’s the justification for one share class paying 70 basis points and another share class paying 40 basis points?” Nadig said. “There is an answer to that sometimes. It could be that, ‘Well this particular institutional share class has a 12b-1 fee because that’s used to offset record-keeping in a 401(k) plan.’ That’s a perfectly legitimate and valid reason for that fund to have an additional expense. However it’s rarely that obvious and clean.”
Kenyon said Perpetual addressed that issue in the filing; it’s proposing the same management fee across share classes. The only thing that would separate the share classes is the operating expenses.
Nadig said that would make sense; ETFs are cheaper to run because they don’t have transfer agencies or present prospectuses.
Either way, most advisors, if given a choice, would probably want to select the ETF share class for the tax benefits, lower costs and flexibility, especially if they’re already fans of a particular manager or strategy, Nadig said.
“Given a choice between the two, what would an advisor have to say to justify hanging onto the mutual fund share class, versus the ETF share class? Pretty hard to figure out what that is.”
