Single-bond ETF manager goes against current by asking SEC for mutual fund share class

A boutique fund manager with a line of single-Treasury-bill ETFs is trying to follow in Vanguard’s footsteps — but in reverse — hoping to add a mutual fund share class to the products.

On Tuesday, F/m Investments filed a request for exemptive relief with the Securities and Exchange Commission for the share class that would accompany the year-old $2.4 billion line of 10 ETFs, citing the much larger asset manager’s success over 20 years in doing the opposite, adding ETF share classes to existing mutual funds.

The small shop isn't the first to try to take advantage of Vanguard’s now-expired patent, which as of May is no longer in effect. In July, for example, Dimensional Fund Advisors asked for the SEC’s blessing to add ETF shares for numerous actively managed mutual funds — something even Vanguard has not been able to secure.

But F/m, which would be adding a mutual fund share class to its US Benchmark ETF line, is the first to propose the opposite. The idea also comes at a time when fund providers have either converted existing mutual funds to ETFs or added separate ETF versions of products. Sales in the U.S. have increasingly favored ETFs, including actively managed ones, as advisors have shown more interest in ETFs than mutual funds — a trend reflective of the products’ lower fees and tax benefits.

But one area where ETFs have been slow to catch on is a big one: the 401(k) market. And that is what F/m has in mind for mutual fund shares of its single-Treasury ETFs, company president Alexander Morris said.

There is “a $6 trillion world out there of retirement plans who are obligate mutual fund buyers,” Morris said. “They’re mutual fund consumers. And mutual fund consumers get cut out of all the innovation happening in the ETF space.”

Many 401(k)s don’t include ETFs for several reasons, ranging from incompatibility with aging record-keeping systems to program rules that simply don’t allow them. Some plans provide access to ETFs through brokerage windows, which is the place where single-stock and single-bond funds are most likely to be found. However, brokerage windows are used most often by active 401(k) investors who want far more options than are available in their plans’ core menus. Whether single-bond products like F/m’s line would make inroads as stand-alone options on 401(k) menus is a question, but such investments could also be used in managed accounts or custom target-date funds.

“They’re definitely swimming against the current here. All the flows, all the interest is going into ETFs, away from mutual funds,” said Bryan Armour, director of passive strategies research for North America at Morningstar Research Services. But he noted that “401(k)s do tend to rely on mutual funds and collective investment trusts, and ETFs make up a very small portion of 401(k) assets.”

F/m could have chosen to file for a separate mutual fund line of the existing ETFs, rather than a share class of them. But that tactic would have allowed the products to diverge slightly, and the firm did not want that, Morris said.

“You hit copy-and-paste over time, and something always changes — we didn’t want that,” he said. “The answer for us is that it should be one account, one security, one trade, two different accounting treatments.”

Although “we got laughed out of a lot of rooms” when the firm announced the single-Treasury-bond ETFs, the products have since attracted enough flows to show their acceptance, and it benefits the company that it is the only player to offer such products, Morris said.

The funds would be additive to 401(k)s and not necessarily be replacing existing managers on plan menus, he said. “No one has done what we’ve done.”

There is demand in retirement plans for some mutual fund versions of ETFs, said Nate Garrison, chief investment officer at Pensionmark.

"Some of the most innovative and lowest-cost products launched today are ETFs," Garrison said in an email. "It would be beneficial to have some of those higher-quality ETF products out there available in plans as funds, as we certainly have demand for it and many existing use cases today."

Along with the SEC application, F/m also filed a patent for the process.

Whether the SEC grants an exemption that would allow a mutual fund share class is a question.

But the products involved address concerns about cash buffers necessary to meet redemptions, as they effectively hold cash exclusively, Armour said.

“I don’t know if it would be able to extend to other products that would require a cash drag,” he said, adding that “there are a lot of layers here that the SEC would need to consider,” such as the precedent that could be set by approving the share class addition or whether F/m, with its patent, would have an unfair advantage.

Of course, the SEC did long ago approve Vanguard’s request, which has been used to add an ETF share class to at least 70 funds.

“They have not approved it for anyone else,” Armour said. “It’s just Vanguard at this point.”