Why the ETF industry is betting big on a new class structure

Key Concepts

Dual Share Class Listings, ETFs, Mutual Funds, SEC, Taxable Events, Clone Strategies, Retirement Plans (401k, 403b), Vanguard Patent, Operational Infrastructure, Cross Subsidization.

Dual Share Class Listings for ETFs and Mutual Funds

The SEC is currently considering dual share class listings, which would allow the same portfolio of stocks to be accessed through both a mutual fund and an ETF format. This shared portfolio would have the same managers and holdings, aiming to reduce taxable events.

Benefits of Dual Share Class

• Tax Efficiency: Reduces taxable events within the portfolio.
• Operational Efficiency: Lowers the back-end costs for issuers to launch a product.
• Access to Growth: Allows traditional asset managers to maintain their lucrative retirement plan business (401k, 403b) while pursuing the higher growth potential of the ETF market.
• Alternative to Clone Strategies: Provides an alternative to clone strategies and mutual fund to ETF conversions.

Historical Context: Vanguard's Patent

Vanguard previously held a patent on this structure, which has now expired, making this development exciting for the industry. Vanguard leveraged this structure to build their ETF business.

Implementation Questions

• Implementation Order: The order in which firms will be allowed to implement dual share classes (whether it will be all at once or staggered) is unclear.
• Operational Plumbing: The operational implications of potentially thousands of new share classes being introduced in a short period are uncertain.

Impact on Mutual Fund to ETF Conversions

The introduction of dual share classes is expected to slow down the conversion of mutual funds to ETFs. If an issuer can simply add an ETF share class to an existing mutual fund, the need for a full conversion diminishes.

Industry Sentiment and Timeline

• Imminent Approval: Lawyers at the Exchange ETF Conference indicated that approval of dual share classes could happen within the next 3 to 6 months.
• High Interest: Approximately 50 firms have already applied for the ability to offer dual share classes.
• Expected Approval: The general industry consensus is that approval is likely before the end of the year.

Operational Readiness

Even with SEC approval, issuers need to ensure their operational infrastructure is ready to support dual share classes. The ability to execute operationally is a key factor.

Potential Concerns and Risks

• Cross Subsidization: The SEC has expressed concerns about cross subsidization, where costs in the mutual fund (e.g., trading costs) could negatively impact ETF shareholders.
• Outflows: Massive outflows from a mutual fund could cause taxable events that negatively impact ETF shareholders.

Quote: "I think overall it's a win for investors" - Nate, acknowledging potential edge cases where it could be negative.

Conclusion

The introduction of dual share class listings has the potential to significantly change the ETF landscape. While there are operational and regulatory hurdles to overcome, the industry generally views this development as a positive step that will benefit investors and asset managers alike. The key will be in the execution and ensuring that potential risks, such as cross subsidization, are properly managed.