Exchange traded funds continue to emerge as a preferred vehicle for many investors, as they recorded net share issuance of nearly $600 billion in 2023. In contrast, long-term mutual funds experienced over $600 billion in net outflows. Still, despite their persistent outflows in recent years, mutual funds have more than double the amount of assets as ETFs in the United States.
In the first half of 2024, active ETFs represented over a quarter of all ETF net inflows, although they are still relatively small when compared to active mutual funds by assets. Perhaps the most significant potential development that could accelerate the growth of ETFs—especially active ETFs—could be the SEC’s approval of exemptive relief for asset managers to offer ETF share classes for mutual funds.
Potential exemptive relief and subsequent product innovation would be a significant development. To help clients navigate the impacts of this changing landscape, it is important for financial advisors to familiarize themselves with the concept of ETF share classes.
What Is an ETF Share Class and What Are the Benefits to Clients?
ETF share classes refers to situations where an ETF exists as a share class of a broader mutual fund with multiple share classes. This concept is not entirely new; Vanguard has offered ETF share classes for its index funds since 2000. It held a patent on the concept for more than two decades before it expired in 2023. ETF share class models also exist today in other countries like Australia and Ireland.
ETF share classes can potentially offer benefits to shareholders of both the ETF and mutual fund share classes.
For mutual fund shareholders, an ETF share class may contribute to lower portfolio transaction costs and greater tax efficiency through in-kind transactions using custom baskets. Shareholders could also potentially exchange their mutual fund for ETF shares, saving on transaction costs and potential tax consequences that may be incurred if they redeem their mutual fund shares and buy separate ETF shares.
For ETF shareholders, investors that prefer the ETF vehicle could gain access to investment strategies of established funds with a performance track record, assets under management and economies of scale. Investor cash flows from mutual fund class transactions may allow for efficient portfolio rebalancing and greater basket flexibility for creations and redemptions through the ETF class. Tax-free exchanges of shares from the mutual fund class may accelerate the development of an ETF shareholder base, which could generate greater trading volume and lower bid-ask spreads and more efficient trading.
Why Now? Recent Requests for Exemptive Relief
Asset managers have been monitoring developments related to the ETF share class model for years as Vanguard’s patent approached its expiration. Since February 2023, more than 30 asset managers have applied for exemptive relief from the SEC to launch ETF share classes. Additionally, the Cboe BZX Exchange filed an application with the SEC in April 2024 to amend its listing standards to permit ETF share classes.
These requests are under consideration by the SEC staff for individual exemptive relief. The ETF industry anticipates a collaborative process of identifying and addressing potential concerns raised by the SEC staff about the ETF share class model. While there is no set timeline for potential approval, ETF issuers have filed for exemptive relief because they believe that the model can provide meaningful potential benefits to shareholders of both ETF and mutual fund classes.
How Financial Advisors Should Prepare
If ETF share classes eventually receive exemptive relief, it could have a momentous impact on the ETF landscape. There are several steps advisors may want to consider in preparation:
1. Educate clients on investment vehicle differences
ETF usage has continued to grow rapidly in recent years due to the structural benefits. Advisors should help clients understand the differences between mutual funds and ETFs, especially differences in tax efficiency and how shares are bought and sold (at NAV for mutual funds and via a brokerage account for ETFs).
2. Assess client portfolios for potential exchange opportunities
One of the likely outcomes of expanded ETF share class exemptive relief would be a massive expansion in ETF availability for strategies that are currently offered only in mutual fund vehicles. A key benefit of the ETF share class model would be the ability for clients to exchange mutual fund shares for ETF shares without having to sell shares and realize a tax impact. If a client holds significant assets in mutual funds, an ETF share class could offer a pathway to improve their tax profile. Advisors should evaluate their clients’ existing mutual fund holdings and consider whether switching to an ETF share class would make sense for certain strategies if they were launched in an ETF share class.
3. Monitor current developments and set realistic timing expectations
Over 30 asset managers have filed for exemptive relief, and the list continues to expand. But there is no guarantee of when—or even if—that relief will be granted. It is important to understand that it may be a lengthy process for asset managers to comprehend and address the SEC staff’s concerns about the ETF share class model. In the meantime, advisors should monitor filings, exemptive relief updates and industry reports to stay informed and help clients navigate trends and opportunities.
Conclusion
ETFs continue to grow, and the possibility of SEC exemptive relief to expand ETF share class options could have significant implications for advisors and their clients. Advisors should prepare by educating clients about investment vehicles, assessing client portfolios and staying informed about regulatory developments. Exemptive relief for ETF share classes may take some time, but if granted, would be a key development that could reshape how advisors construct portfolios and deliver value to their clients.
Matt Barry is Head of ETFs at Touchstone Investments
