SEC edges closer to decision on ETF share classes

The US Securities and Exchange Commission has taken a significant step toward allowing mutual funds to offer exchange-traded fund share classes, a move that could reshape the landscape for asset managers and retail investors alike.

On Monday, the SEC issued a notice of intent to grant Dimensional Fund Advisors permission to launch ETF share classes within its mutual funds. While the order is currently open for public comment, industry observers expect it will pave the way for dozens of similar applications, potentially leading to a surge in new ETF offerings.

The agency’s decision follows the expiration of a long-standing Vanguard patent in May 2023, which had previously limited the dual-share class model to a single firm .

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

Under the proposed change, mutual funds could offer investors the option to participate in their portfolios via ETF shares, which can be traded throughout the day at market prices. This stands in contrast to traditional mutual fund shares, which are bought or sold at the day’s closing price.

Proponents say the shift could make existing funds more accessible to investors who value the lower costs, tax advantages, and liquidity associated with ETFs.

Brian Daly, director of the SEC’s investment management division, described the move as one that increases choice and reduces expenses. In an interview with Reuters, Daly said it “makes the innovation of the ETF ... more accessible to the average retail investor.”

Following the news, Dimensional’s co-chief executive officer, Gerard O’Reilly, said that the firm is “enormously pleased” with the SEC’s decision, calling it a “win for investors.”

"Investors may soon see a wave of ETF share classes, which makes it more important than ever for investors to look beyond the investment wrapper and to the investment proposition within," O' Reilly said in a blog post. 

The SEC’s order is expected to include safeguards to address potential conflicts of interest between share classes and to ensure proper disclosures for investors. Currently, asset managers seeking to launch an ETF must create a new fund from scratch and cannot market it using the mutual fund’s track record. The new approach would allow managers to port over performance histories, potentially leveling the playing field between mutual funds and ETFs.

There is no shortage of interest from asset managers. According to the SEC, about 80 applications similar to Dimensional’s are pending. The agency has indicated that once the first approval is finalized, subsequent applications are likely to move forward quickly.

Despite the scores of asset managers who have filed to add ETF share classes to existing mutual funds, Todd Rosenbluth, head of research at TMX Vettafi, says the firm "expects the vast majority to take a wait and see approach.

"Once the seal is removed there is no turning back. There are many logistical issues that need to be addressed and asset managers can afford to be patient," he said. "We expect the supply of ETFs to gradually increase in the fourth quarter due to the regulatory approval but it has already been an impressive year with hundreds of actively managed ETFs new to market."

"We applaud the SEC’s indication of its intent to grant exemptive relief to allow asset managers to offer mutual funds and ETFs as separate share classes under the same portfolio. This decision is an important step to expanding investor choice and fostering a more competitive marketplace," Eric J. Pan, president and CEO of the Investment Company Institute, said in a separate statement. 

Read more: Dual-share class hopes grow higher with filings from Pimco, T. Rowe Price

However, not all industry participants are enthusiastic. Research from Cerulli Associates, in partnership with Nicsa, suggests that many wealth managers and intermediaries are wary of the operational, compliance, and business challenges associated with dual-share-class products.

“A key pain point will be the exchange mechanism. Solving the infrastructure gaps will be costly, resource-intensive, and there are many unknowns,” said Chris Swansey, associate director at Cerulli, in a statement announcing the research in May.

O'Reilly himself alluded to the friction in Dimensional's response, acknowledging investor demand "for the ability to exchange mutual fund shares for ETF shares without incurring transaction costs or taxes.

"[I]nvestors’ custodial platforms will need to facilitate these transactions, and readiness will likely vary across platforms," he said. "While we plan to work closely with custodial platforms and the fund’s transfer agent to facilitate these transactions, we do not need to wait for their readiness to launch ETF share classes." 

While asset managers see the dual-share-class option as a way to offer investors their preferred structure and benefits, Cerulli’s research notes that the rollout is likely to be gradual as firms address regulatory and operational hurdles.

There's a chance advisor adoption will be uneven as well, as the report determined wirehouses and broker-dealers would risk losing up to $30 billion in fees a year that they currently collect from mutual funds sold to customers.

Jim Fitzpatrick, president and CEO of Nicsa, said asset managers “must be selective about which products to offer ETF as a share class, with mindfulness for what intermediaries and advisors want.”