In a move anticipated for two years, the Securities and Exchange Commission signaled earlier this week that it would grant exemptive relief to Dimensional Fund Advisors’ application to offer dual share class funds. It also held a call with representatives from dozens of other asset managers that had filed for relief, directing them to update their applications to look more like Dimensional’s to speed up the approval process.
Up to now, Vanguard had been the only asset manager allowed to offer dual share class funds—i.e., funds with both mutual fund and ETF share classes. Vanguard’s patent expired in 2023, and in the time since, there’s been an ever-growing list, starting with Dimensional, of managers looking to employ the structure.
But now that the dogs have caught the proverbial car, what happens next? How quickly will asset managers move? How set up are they for the administrative tasks involved with managing dual-class funds? Will the market be flooded with new ETF share classes of existing mutual funds? And what sorts of administrative and tax headaches will asset managers and advisors have to deal with if existing investors in mutual fund share classes want to flip to the new ETF share classes? In addition, how well set up are custodians to handle the additions and the potential moves by investors?
Even in advance of the SEC’s move, there’s been speculation that the process might take longer than many are expecting. Asset managers may still have work to do behind the scenes before moving forward and they may be strategic in choosing what funds to offer dual shares. In other words, the pace of launches may be more of a trickle than a flood.
For investors looking to switch, funds that add ETF share classes are likely to offer “exchange privilege,” meaning existing investors “wouldn’t have to sell their mutual fund shares to purchase a stake in the equivalent ETF share class, which could trigger capital gains distributions and taxes. Instead, bolting on an ETF share class gives them the tax advantages of the ETF’s redemption mechanism that can reduce, if not eliminate, capital gains distributions,” according to an analysis reacting to the move by Morningstar’s Daniel Sotiroff and Bryan Armour. “Investors in the mutual fund share classes are the biggest benefactors. The ETF share class can purge stocks and bonds with built-up capital gains through its in-kind redemption mechanism. In-kind creations and redemptions keep the ETF tracking the fund’s net asset value throughout the day while cleansing its portfolio of potential capital gains distributions.”
WealthManagement.com also reached out to some advisors to get their thoughts.
“The transition to an ETF share class at a qualified custodian does remain a question mark,” according to Grant Engelbart, investment strategist at Carson Group. “Historically, this has realistically only occurred through Vanguard’s website. Appropriate custodians will need to be able to offer this feature for it to make a meaningful impact across the industry.”
However, ETF share classes “should enhance the tax efficiency of the existing mutual fund share classes,” Engelbart added. That could mitigate the need to move to the ETF share class because similar benefits would become available to mutual fund shareholders.
He also said he expected issuers to be selective.
“Mutual funds that claim some level of tax efficiency would be a likely candidate, but certain asset classes where the managers value less transparency may not want an ETF with holdings published daily,” he said. “Less liquid asset classes and strategies that rely on higher levels of holdings concentration may want to preserve their ability to close to new investors, and therefore would not implement an ETF share class, which would eliminate their ability to do so.”
Zac Murphy, a financial planning associate and investment analyst at Jacksonville Beach, Fla.-based Ullmann Wealth Partners, pointed to another potential benefit: fund managers could use the structure to reduce embedded capital gains in fund portfolios.
“Large, random capital gains distributions have been one of the largest downsides to investing in mutual funds in taxable accounts over the years,” Murphy said. “This has also been one of the many reasons why ETFs have found so much popularity. With this new structure, we are likely to see less surprises from mutual funds reporting meaningful annual capital gains distributions. Perhaps creating a boost in demand for mutual fund share classes.”
Stephen Tuckwood, director of investments at Modern Wealth Management, also highlighted potential benefits to clients invested in mutual funds.
“By becoming an extension of a share class of an existing fund, the hope is for relief to be granted where existing mutual fund investors can elect a share class conversion to the ETF as a non-taxable event,” Tuckwood said. “Standard share class conversions can typically be performed at scale across an advisor’s entire holding at the custodian and are common practice for most RIAs. One potential challenge is that mutual funds offer fractional shares, but ETFs do not, so small positions of the original mutual fund may get left behind.”
Tuckwood added that the difference in how ETFs and mutual funds trade (with ETFs publicly listed and valued at bid-ask spreads vs. mutual fund orders filled at net asset values).
“ETFs tend to be more tax-efficient given their ability to meet redemption requests in-kind, whereas with mutual funds, the actions of other investors in the fund can create unwanted tax consequences for holders,” he said.
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