Executive Summary: While Vanguard may be a holdout now, more than 50 other fund firms want to offer ETF share classes for their traditional mutual funds—but the SEC hasn’t said yes (yet). As I believe it’s only a matter of time before Vanguard joins the fray, I break down the benefits, questions, and complications of this dual-share class structure, as well as what it could mean for fund investors.
Exchange-traded funds (ETFs) have been eating away at mutual funds’ dominance for years now. Legacy mutual fund companies are searching for a response. One solution they are eager to adopt is tacking an ETF share class onto an existing active mutual fund. The only problem? So far, regulators have said N-O.
However, the Securities & Exchange Commission, or SEC, is rethinking its stance. An IVA reader sent me a CNBC article reporting that with about 50-plus fund companies seeking SEC permission, the regulator is now “prioritizing the issue.” The IVA reader asked:
Is Vanguard one of the asset managers seeking the SEC’s approval to launch ETF share classes of its active mutual funds? Can you comment on this?
The first question is easy. So far, Vanguard has not asked the SEC for what is called “exemptive relief” to offer ETF share classes of its active mutual funds.
Of course, Vanguard could request permission at any time. They have tended to take a wait-and-see approach to significant changes in the industry before committing fully. But even if Vanguard doesn’t go down this road, ETF shares of actively managed mutual funds may be on the way.
ETFs 101
Starting at the beginning, what are exchange-traded funds (ETFs)?
The short story is that ETFs are mutual funds, typically index funds, that you can trade like stocks throughout the day—think of them as mutual funds version 2.0. It should come as no surprise that in developing version 2.0, the Wall Street wiz-kids made some improvements.
ETFs’ purported advantages are increased liquidity (you can trade throughout the day), transparency (their portfolios, for the most part, are updated daily) and tax-friendliness.
I’ll give ETFs the nod over mutual funds in terms of transparency and tax-friendliness. However, the ETF’s intraday trading feature is a questionable benefit. It may be advantageous for some investors, but it can be a losing proposition for others, particularly those accustomed to trading mutual funds at their net asset value (NAV) at the end of each day, as it adds complexity.
Still, ETFs have become exceedingly popular, so you can see why mutual fund companies are eager to find a way to incorporate the ETF model.
Why Are ETF Share Classes Hot?
As I mentioned, ETFs have been taking market share from mutual fund companies for years. Part of the explanation is investors' shifting preference for ultra-low-cost index offerings. ETFs are often the cheapest way to invest in an index—sometimes even cheaper than Vanguard’s index funds.
However, another attraction is that ETFs are perceived as a “better” fund structure than mutual funds—particularly when it comes to taxes. Investors are tired of mutual funds kicking out big capital gains year after year, so they are turning to ETFs, which rarely distribute capital gains.
Adding ETF share classes to existing actively managed mutual funds won’t solve the problem of investors favoring index funds, but it could solve the tax issue. The dual mutual fund–ETF share class structure could remove one objection to owning actively managed funds (at least in taxable brokerage accounts).
Mutual fund companies are also motivated by their bottom lines. If you are, say, T. Rowe Price, you want your mutual funds to be broadly available on different platforms—Fidelity, Schwab, E*TRADE, Vanguard, etc. However, T. Rowe Price pays a hefty fee (usually a percentage of the fund’s expense ratio applied to assets held at the platform) for shelf space for its mutual funds.
(Note: Vanguard does not do this, so you typically have to pay a transaction fee when buying a Vanguard mutual fund on the “other” platforms.)
ETFs, which are listed on the stock exchanges, don’t face those tolls. You can buy them through virtually any U.S. brokerage account. So, an asset manager would get to keep a larger cut of their ETF expense ratios than they would for a mutual fund, even if they are share classes of the same fund.
In other words, follow the money!
Of course, the dual mutual fund–ETF share class structure already exists in one place: Malvern, PA.