In late April, asset manager PGIM filed a request with the SEC for free relief to offer existing mutual fund shares in the form of ETFs. PGIM joins several other asset managers, including Fidelity InvestmentsMorgan Stanley Investment Management and Dimensional Fund Advisors, seeking permission to offer this dual equity asset class.
According to its website, PGIM operates over 70 mutual funds, ranging from the PGIM Total Return Bond Fund to the PGIM Jennison International Opportunities Fund.
The adoption of a dual equity asset class would be a “potential game changer for both mutual funds and ETFs,” said Matt Collins, head of ETFs with PGIM Investments.
“ETF is open architecture for any type of client. And the mutual fund can be a little more geared towards the distribution side. To the extent that we can bring the scale that we have and provide access to a new type of customer, that's the whole point outside of the efficiencies of scale and the tax benefits that come along with it,” he noted.
Collins added that potential investors would benefit from participating in one of PGIM's existing multibillion-dollar funds, rather than a newly launched ETF with a much smaller net asset value.
In March, mutual funds saw $11.2 billion in outflows, while ETF inflows totaled $102.5 billion, according to a report from consulting firm Cerulli & Associates.
Making mutual funds available as ETFs is attractive to PGIM and other asset managers because it would create efficiencies of scale by allowing two different types of funds to operate from the same portfolio, according to Aniket Ullal, vice president of data and ETF analytics. with research firm CFRA.
A dual-share structure would also pave the way for ETF issuers to enter the nearly $7 trillion 401(k) market that remains largely closed to them, said Aisha Hunt, a principal with law firm Kelley Hunt. Kelley Hunt currently represents F/m Investments, a subsidiary of Diffractive Management Group, in its application for exemptive relief to offer its ETFs in a mutual fund share class.
According to Bryan Armour, director of passive strategies research, North America, with Morningstar, a dual-stock structure is also likely to be a hit with RIAs. “This allows mutual funds to meet investors where they are. If one prefers ETFs, they can choose an ETF. And it would be a way for you to offer an ETF from an existing strategy while holding your mutual fund in retirement plans,” he said.
Some asset managers are already doing this by launching ETFs that clone their mutual fund strategy, “but then it creates all kinds of distribution problems,” Armor said. For example, wire with access to platforms that sell both the mutual fund and the ETF version may pull their money from the mutual fund to the ETF because it is cheaper.
Ullal points to mutual fund-to-ETF conversions as an indicator of the level of investor demand there may be for a dual-equity asset class. “A company like Dimensional has had a lot of success converting mutual funds into ETFs, and the demand was pretty strong,” he said.
For example, Dimensional Fund Advisors converted a mutual fund into Dimensional US Core Equity ETF 2 (DFAC) in June 2021. The ETF currently holds $26.7 billion in net assets, up from $21 billion at the time of the conversion. The fund has seen $9.5 billion in inflows since registration. In 2023, it gave a return of 21.86%.
In all, there have been 78 mutual funds that have converted to ETFs so far, with three funds closing after the conversion, according to Morningstar data. Net inflows to these funds since converting to ETFs totaled $21.6 billion as of March 31. However, when ETFs managed by Dimensional Fund Advisors were removed from the total, the remaining funds saw approximately $1.5 billion in net outflows after the conversion.
“Dimensional has been significantly more successful than everyone else,” Armor said. For example, JP Morgan Realty Income ETF (JPRE) experienced $666 million in outflows since the conversion, while EA Bridgeway Omni Small Cap Value ETF (BSVO) no outflow of $560 million.
In Ullal's view, the mutual funds that are likely to get the most attention from RIAs if offered as a dual-equity asset class are those that already see strong demand from that channel. “I think that's probably going to be of more interest in the active equity and active fixed income space. These would be the growth areas because the index area is already very mature,” he said.
Collins confirmed that PGIM was looking at dual share offerings for mutual funds with “popular strategies” to avoid creating competition between its various funds. Additionally, “for those types of strategies where there are serious capacity constraints, we might think twice about having an ETF just because an ETF is more difficult to manage,” he said.
How likely is approval?
The SEC has no time limit for responding to asset managers' requests for free release. However, in early April, Cboe Global Markets asked the SEC to approve the addition of dual-stock ETFs to existing mutual funds. According to Armour, the SEC will have until the end of the year to respond to this request.
For the most part, market watchers are optimistic that the SEC will eventually approve dual share structures.
“I think it's very likely the SEC will grant relief,” Hunt said. “For now, Vanguard is operating dual class models that have benefited from cheap facilities; they have a monopoly on that structure. The SEC should consider that the Vanguard model exists.”
Vanguard secured a patent in the early 2000s, allowing it to offer a class structure with dual shares for its mutual funds for over 20 years. That patent has expired in May of last year and was awarded only to passive funds, according to Armour. He noted that Vanguard's request to use dual stocks for its actively managed funds was denied.
The SEC has some concerns about the use of dual shares for mutual funds/ETFs. The first is that mutual funds are required to hold a certain amount of cash reserves to meet redemptions, while ETFs can use securities instead of cash to trade “in kind.” Hunt noted that, as a result, SEC officials worry about mutual fund reserve requirements creating a drag on money into ETFs and putting ETF investors at a disadvantage.
Another potential issue is how the funds will be paid for. Hunt noted that mutual funds typically pay for expenses, other than the management fee, outside of the fund's assets. With ETFs, on the other hand, the manager usually pays for the fund's expenses. This mismatch can also lead to investors in one share class paying for the expenses of another. “One of the things we're doing in our application is proposing that the unit fee be charged for both classes,” Hunt said.
Collins agreed that a number of details about the transaction costs and tax efficiencies surrounding a dual-share asset class still need to be disclosed to satisfy the SEC's concerns.
Still, Hunt believes hybrid funds will be the way of the future, and RIAs should start familiarizing themselves with how such vehicles will work.
“Managers will be encouraged to have dual class models,” she noted. “Ultimately, the investment universe is going to transform into hybrid funds, so it's really important that RIAs understand the implications of dual share classes for their clients.”