ETF experts are predicting that a formerly patented structure for creating ETF share classes from existing mutual funds will soon become widely adopted because of its considerable tax advantages.
With the expiration in May of the patent that Vanguard held on the structure, which it launched in 2001, mutual funds across the spectrum should now be considering how to adopt it for their own operations, according to Phil Bak, chief executive of Armada ETF Advisors, a REIT and ETF manager, and the former CEO of ETF subadvisor Exponential ETFs.
Mutual funds are watching with great interest to see how the SEC responds to the first applications for exemptive relief from companies hoping to implement the Vanguard structure, according to Jeremy Senderowicz, an attorney at Vedder Price.
“I think everyone is watching those,” he said. “We’ll see if the SEC is willing to grant the exemptive relief to other players in the market.”
So far, only two companies have asked the SEC for permission to follow Vanguard’s example.
In February, PGIA, the U.S. division of Australian asset-management firm Perpetual Ltd., filed a request for exemptive relief that would allow it to follow in Vanguard’s footsteps.
In July, Dimensional Fund Advisors filed another request that included a promise that the boards responsible for Dimension’s U.S. mutual funds would initially and periodically evaluate use of the multi-class structure to determine whether the use of ETF shares is in the best interest of each mutual-fund and ETF class individually, according to an analysis posted in July by law firm Ropes & Gray.
“There’s a lot of interest right now, but I would say however much interest there is, it’s not enough,” Bak said. “This is a real earth-shattering event in the mutual fund space; this is extremely impactful and significant to mutual fund boards and mutual fund companies.”
There’s no clear indication yet which way the SEC will jump, but it would seem anti-competitive for a federal agency to keep other companies from following a path so well-worn by Vanguard, Bak said.
Funds with benefits
The Vanguard structure conveys tax advantages to the fund by cleaning out the cost basis of the stocks not only for the ETF, but for the mutual fund as well, to cut the fund’s capital gains taxes. “By virtue of having an ETF share class, the mutual fund itself becomes significantly more tax efficient,” Bak said.
For example, when shareholders in a mutual fund with an ETF share class sell shares, the fund is able – with the help of a broker or other authorized participant – to meet the redemption by exchanging the underlying stock for ETF shares, rather than by selling the underlying stock for cash that is subject to capital gains taxes, Bak said.
The practice is not without controversy, but the IRS has ruled, based on a Nixon-era tax code addition covering investments, that the stock-shares-for-ETF-shares exchange—the in-kind transfer—is not a taxable event.
Every mutual fund complex should be adopting an ETF share class via a Vanguard-type structure, Bak said, because the potential benefits are so significant and the costs and potential SEC hurdles are minor in comparison. Mutual funds with low turnover will benefit the most, but any fund that can take advantage of the in-kind creation/redemption process—where stock shares are exchanged for ETF shares—will enjoy tax benefits.
“The board is overseeing on behalf of the investors in the funds, and there’s no doubt that when it comes to the investors in the fund that managing taxes to the benefit of the investors in the fund is in their interests. It’s what they want,” Bak said.
Mutual funds with long-held stocks with low-cost bases will reap the most tax benefit, according to Robert Tull, president of Procure Holdings, who has launched more than 400 ETFs.
“For a lot of these funds that have been around forever, that’s fairly important,” Tull said. “If it’s a fund that’s only three years old, it’s probably not as much of a benefit as for a fund that’s been around for 25 years.”
Fund boards should also consider the Vanguard structure as a way to tap into the overall asset growth advantages of ETFs for the benefit of fund shareholders, according to Ryan Charles, partner at Kelley Hunt & Charles.
ETF growth has outpaced that of traditional mutual funds for years, most recently with net inflows of $611bn for U.S. ETFs in 2022, compared to net outflows of $1.1trn for long-term U.S. mutual funds, according to the Investment Company Institute.
“It makes a lot of sense to be thinking about this and potentially advising folks at a high level to be very thoughtful about what’s going on in the marketplace and what they should be thinking of as a fiduciary,” Charles said.
SEC hurdles
The biggest potential SEC obstacle is whether the agency will grant the exemptive relief to allow others to use the Vanguard structure, according to Senderowicz, the Vedder Price attorney.
“It’s out of step with the ETF standard that was established under the ETF rule, and it’s always tougher to get the SEC to agree to something different than the standards they have established in a rule,” Senderowicz said.
The SEC did express concern in a staff bulletin posted Feb. 2 about whether having ETFs and mutual fund share classes in the same fund could lead to shareholders in one share class indirectly subsidizing other shareholders by paying more than their fair share of fees and expenses, Senderowicz said.
However, the tax advantages of the Vanguard structure would not seem to be much of a hurdle. “I’m not sure that’s really something that is a major issue for the SEC, because the SEC has recognized through the years the extent to which ETFs are usually more tax-efficient than mutual funds, and it’s not something that they have an objection to,” Senderowicz said.
Another question is whether mutual funds that seek exemptive relief from the SEC will be required to report their holdings daily or if they will be permitted to mask their portfolio. Based on precedent, it would seem that a fund seeking to use the Vanguard structure would have to commit to full portfolio transparency, Senderowicz said.
Some mutual funds with active equity trading strategies may decide not to add an ETF share class because of the daily disclosure requirement, which could open the fund up to front running, Bak said.
For a fee, funds may be able to mask their daily holdings through a semi-transparent ETF methodology licensed from providers such as Blue Tractor, Fidelity Investments, Precidian Investments or T. Rowe Price.
Vanguard applied its structure to passively managed index funds, but that shouldn’t be an obstacle for firms looking for SEC approval for an actively managed mutual fund, as long as all share classes are fully transparent on a daily basis, Senderowicz said.
Some critics of the Vanguard structure have labeled it a tax siphoning scheme, but Bak said tax issues wouldn’t be relevant in the SEC’s review. The SEC’s only role would be to decide whether the Vanguard structure is compliant with the Securities Exchange Act of 1934 and the Investment Company Act of 1940.
Tull said the structure doesn’t avoid taxes; it simply passes them on to the broker-dealer side. “It’s typically a misunderstanding on the part of the media and many of the people who invest in ETFs that they think it’s tax avoidance, but it’s not. It’s tax minimization.”
Wanted: ETF expertise
For the mutual funds that take on the Vanguard structure, fund boards and fund managers will probably need to add ETF capital markets expertise to manage the ETF and work with the market makers—such as brokerage houses that exchange stock held by a fund with shares of the ETF to allow the fund to reduce its capital gains, Bak said.
“There are some operational hurdles to overcome, but none of them are insurmountable,” he said, and none of them outweigh the tax benefits to the funds’ shareholders.
To achieve the ETF tax efficiency, the fund must swap out shares it wants to get rid of—selected for their cost basis—through market makers based on creation and redemption activity.
“It’s not the hardest process in the world to master, but there is some technical knowledge required,” Bak said. “Mutual fund companies would be wise to start acquiring that knowledge now,” which would probably mean hiring portfolio managers, consultants or others with experience managing ETFs and familiarity with market makers and the creation-and-redemption process.
As fiduciaries, fund trustees need to consider whether they have the right infrastructure and people in place to manage and advise on the various aspects of ETFs, Charles said.
That includes the need to comply with additional stock-exchange rules as well as the need to pass muster with the SEC. Board members will also have to be educated on the creation and redemption process for ETF shares and about the interaction with authorized participants, he said.
“There’s a number of things that can come up in the day-to-day mechanics of an ETF, compared to a traditional mutual fund, and that’s where, as a trustee, you want to be comfortable that you have the right people in place to set up that structure,” Charles said.
Eventually, mutual fund board members will become well-acquainted with ETF operations as the structure becomes commonplace, Bak predicted.
“Once all these fund companies are up and running with the processes and the capital market side of things, it’s a realistic scenario where every mutual fund has an ETF share class and they’re managed as such, and it becomes standard process,” he said. “That’s the end game that we’re going to get to with this.”
