Exchange-traded funds continue to emerge as a preferred vehicle for many investors, as they recorded net equity issuance of nearly $600 billion in 2023. In contrast, long-term mutual funds experienced over $600 billion in net outflows. However, despite their steady outflows in recent years, mutual funds have more than twice the amount of assets as ETFs in the United States.
In the first half of 2024, active ETFs represented over a quarter of all net ETF inflows, although they are still relatively small when compared to active mutual funds by assets. Perhaps the most important potential development that could accelerate the growth of ETFs—especially active ETFs—could be the SEC's approval of exemptive relief for asset managers to offer ETF share classes to mutual funds.
Potential exemption relief and subsequent product innovation would be an important development. To help clients navigate the impacts of this changing landscape, it is important that financial advisors become familiar with the concept of ETF share classes.
What is an ETF share class and what are the benefits for clients?
ETF share classes refer to situations where an ETF exists as one share class of a broader mutual fund with multiple share classes. This concept is not entirely new; Vanguard has offered ETF share classes for its index funds since 2000. It held a patent on the concept for more than two decades before it expired in 2023. ETF share class models exist today in other countries as well such as Australia and Ireland.
ETF share classes can potentially provide benefits to shareholders of ETF share classes and mutual funds.
For mutual fund shareholders, an ETF share class can contribute to lower portfolio transaction costs and greater tax efficiency through in-kind transactions using custom baskets. Shareholders can also potentially exchange their mutual fund for ETF shares, saving on transaction costs and potential tax consequences that may be incurred if they redeem their mutual fund shares and purchase individual ETF shares.
For ETF shareholders, investors who prefer the ETF vehicle can access the investment strategies of established funds with a track record of performance, assets under management and economies of scale. Investor cash flows from mutual fund class transactions can allow for efficient portfolio rebalancing and greater basket flexibility for creations and purchases through the ETF class. Tax-free exchanges of shares from the mutual fund class can accelerate the development of an ETF shareholder base, which can generate greater trading volume and lower bid-ask spreads and more efficient trading.
Why now? Recent requests for exempt relief
Asset managers have been monitoring developments regarding the ETF share class model for years as Vanguard's patent neared its expiration. As of February 2023, more than 30 asset managers have applied for exemptive relief from the SEC to launch ETF share classes. Additionally, the Cboe BZX Exchange filed an application with the SEC in April 2024 to amend its listing standards to allow ETF share classes.
These requests are being reviewed by SEC staff for individual release. The ETF industry envisions a collaborative process for identifying and addressing potential concerns raised by SEC staff regarding the ETF share class model. While there is no set timeline for potential approval, ETF issuers have filed for exemptive relief because they believe the model could provide potentially meaningful benefits to shareholders of ETF and mutual fund classes.
How financial advisors should prepare
If ETF share classes eventually receive exemptive relief, it could have a significant impact on the ETF landscape. There are several steps advisors may want to consider in preparation:
1. Educate clients about the differences in investment vehicles
ETF usage has continued to grow rapidly in recent years due to structural benefits. Advisers should help clients understand the differences between mutual funds and ETFs, particularly the differences in tax efficiency and how shares are bought and sold (at NAV for mutual funds and through a brokerage account for ETFs).
2. Assess client portfolios for potential exchange opportunities
One of the potential outcomes of the expanded relief of the ETF share class exemption would be a massive expansion of ETF availability for strategies currently offered only in mutual fund vehicles. A key benefit of the ETF share class model would be the ability for clients to exchange mutual fund shares for ETF shares without having to sell shares and realize a tax impact. If a client has significant assets in mutual funds, an ETF share class can provide a route to improve their tax profile. Advisers should evaluate their clients' existing mutual fund holdings and consider whether switching to an ETF share class would make sense for certain strategies if they were launched in an ETF share class.
3. Monitor current developments and set realistic expectations for time
Over 30 asset managers have applied for exemptive relief and the list continues to grow. But there's no guarantee when — or even if — that relief will be granted. It is important to understand that it can be a lengthy process for asset managers to understand and address the SEC staff's concerns about the ETF share class model. Meanwhile, advisors should monitor filings, relief release updates and industry reports to stay informed and help clients navigate trends and opportunities.
CONCLUSION
ETFs continue to grow, and the possibility of SEC exemption relief to expand ETF share class options could have significant implications for advisors and their clients. Advisers should prepare by educating clients about investment vehicles, evaluating client portfolios and staying informed of regulatory developments. Easing the exemption for ETF share classes may take some time, but if granted, it would be a key development that could reshape the way advisers build portfolios and deliver value to their clients.
Matt Barry is Head of ETFs at Touchstone Investments