SEC decision on dual-share class funds nears, with major implications for advisors

The US Securities and Exchange Commission is approaching a decision that could reshape the landscape for mutual fund and ETF providers, as well as the advisors who use them.

Asset managers including BlackRock and State Street are awaiting word from the regulator on whether they can offer exchange-traded fund share classes within existing mutual funds – a structure previously exclusive to Vanguard until its patent expired in 2023.

Kaitlin Bottock, assistant director at the SEC’s division of investment management, signaled at an industry event this week that the process is nearly complete, according to reporting by Bloomberg.

“We are finalizing our process,” Bottock said Wednesday at an Investment Company Institute event in Nashville. “We’re at the one yard line."

Bottock clarified that her comments reflected her own views and not those of the commission or its staff as a whole.

Optimism about SEC approval has grown since March, when then-acting chair Mark Uyeda directed staff to prioritize reviewing the numerous applications submitted by fund firms after Vanguard’s patent expired. Dimensional Fund Advisors was among the first to amend its application, signaling momentum for the new structure.

If approved, the dual-share class model could offer mutual fund firms a way to stem outflows and provide clients with greater tax efficiency. However, industry observers caution that implementation may not be immediate. Asset managers would still need to coordinate with custodians, distribution platforms, and trading partners before rolling out the hybrid funds on a broad scale. 

The move could also have significant economic consequences for brokerage firms. According to research from Cerulli Associates, brokerages could lose between $15 billion and $30 billion annually in fees if fund companies widely adopt ETF share classes.

These estimates are based on the potential conversion of all nonretirement or institutional mutual fund assets to the new structure, a scenario Cerulli describes as “very unlikely” in the near term but still worth weighing for its disruptive potential.

Cerulli’s analysis points to a possible shift in business models, with revenue sharing between fund companies and brokerages as one potential outcome. However, the specifics of such arrangements remain uncertain.

One asset management executive interviewed for the report questioned how revenue sharing in ETF share classes might affect traditional ETFs, noting, “If they have the expectation of revenue sharing in an ETF share class, how do they then justify not seeking that on traditional ETFs? That would be so painful.”

Other professionals on Wall Street have also warned the move could take away from some key benefits of the ETF wrapper, particularly its ability to avoid capital gains taxes by offering in-kind redemptions to authorized participants rather than having to redeem in cash. 

“I’ve been in the ETF business for 20 years — we have spent it talking about how great they are at managing capital gains, and I don’t think folks have an appreciation for how more ETFs could potentially end up paying capital gains distributions,” Brandon Clark, director of ETF business at Federated Hermes and former executive at Vanguard, told Bloomberg previously. 

For now, Cerulli expects adoption of ETF share classes to be “limited,” with the greatest impact likely in the RIA channel. Managers most interested in the opportunity are focusing on RIAs, who tend to be the heaviest ETF users and typically charge clients a fee based on assets managed.

"[T]he question is whether adoption among registered investment advisors (RIAs) materializes and eventually pressures other channels," Cerulli said.