Peter Shea and Paul Miller of Seward & Kissel LLP discuss the potential arrival of ETFs as a share class in the US, explaining the likely impact the regulatory change will have on the US ETF industry.
This episode is brought to you in partnership with Seward & Kissel LLP.
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Beverly Chandler
Hello, my name is Beverly Chandler and I welcome you to our latest Off the Record podcast for ETF Express. I’m here with Peter Shea and Paul Miller of Seward and Kissel LLP, to discuss the expected arrival of ETFs as a share class in the US. Welcome gentlemen and first of all, let me ask you to introduce yourselves. Paul, do you want to go first?
Paul Miller
Certainly. Thanks for having us, Beverly. We really appreciate it. I’m Paul Miller. I’m a partner in the Investment Management Group at Seward and Kissel. I focus on registered funds, ETFs and registered adviser matters here in the US.
Beverly Chandler
And then Peter, would you like to introduce yourself?
Peter Shea
Certainly, Beverly, thank you for having us. I’m a partner in the New York Office of Seward and Kissel in Investment Management and I’ve been specialising in ETFs as well as other exchange traded products for many years now and work with a variety of regulated funds.
Beverly Chandler
And so we’re here to discuss this whole new phenomenon in America – ETFs as a share class. I don’t know which one of you wants to go first, but you could tell me what are ETFs as a share class?
Peter Shea
ETFs traditionally understood in the United States are basically a single fund of a single share class. Mutual funds, again it’s a single fund, but it can have multiple share classes. And the multiple share classes are differentiated by having different expenses, sales expenses, administrative expenses and things like that. What they cannot have is different advisor fees. So every share class of a mutual fund has to have the same advisory fee. Since about 2001 or so, Vanguard has had a ETF share class appended to mutual funds and that was granted approval by the SEC, principally on the basis that the ETF share class in the US has certain tax benefits that the mutual funds don’t enjoy; that the tax benefits in the ETF share class would actually in fact be a benefit to the mutual funds by being able to manage for positive tax consequences in the total funds portfolio by using what we an call in-kind exchange mechanism where ETF shares are created in-kind. Shares for a basket of securities or, you know, in redeeming they do the same thing in redemption in reverse, they take in shares of the ETF class and then they would issue out a deposit back basket of securities. Paul, you want to get to where we’ve gotten to now?
Paul Miller
Sure. And Vanguard was granted a patent in the early days which expired in 2023, and since the issuance of the order to Vanguard there has been adoption of Rule 6c-11 in the United States, which basically set the standard for what is required to launch an ETF in the US. And at the time of the adoption of 6c-11, which has really been a boon to the investment management industry in a way because you no longer have to wait for the SEC to issue an order to issue shares of an ETF. At the time of that rule adoption they determined not to permit – or adopt as part of the rule – the ETF share class as a part of a mutual fund. And so with the adoption of 6c-11 and now with the expiration of the Vanguard patent, it’s become an opportunity for other investment management firms, asset management organisations, to tack on if you will an ETF share class to their existing mutual funds. And there are benefits to doing so, which we’ll touch on. There was the rush to seek exemptive relief from the SEC, which is what’s required to offer this ETF share class as part of a mutual fund. Started at the expiration of the Vanguard patent, with the perpetual filing. Since that in 2023 there have been about 50 other asset managers and funds that have filed for such relief. That process was grinding along until really the change in administrations here in the US, the SEC was in the process and the staff was in the process of asking questions of the applicants. What are the risks to existing shareholders of having an ETF share class? What are the benefits? What are the disadvantages? They were pursuing that and then with the change in administration, it’s become clear that the SEC is ready to move on the relief that’s been out there now for a couple of years. And so they’ve asked applicants to take a look at their application. They’ve provided comments to one applicant in particular who’s since amended their filing, their exemptive application filing, and the staff has now asked remaining applicants to conform, if they’re interested in moving forward, their filings to the model that they provided. So that’s where we stand today. It looks like it’s on the immediate horizon, which I think many are excited about, at least on the investment management side of things.
Peter Shea
One other thing going on is a couple of the applications that Paul’s been talking about deal with ETFs getting mutual fund share classes. So there’s a reverse process being pursued in parallel here for those kinds of situations as well.
Beverly Chandler
So this interests me as to why would either want to do these things, so why would a mutual fund want to have an ETF share class? And why would an ETF want to have a mutual fund share class? What advantages do either of those structures bring?
Paul Miller
At the end of the day, it’s about distribution and making your shares available to the widest audience available, and so you have investors that have now been exposed to ETFs for a number of years and have become comfortable with it, you know, and I’ll let Peter speak to some of maybe the generational aspects of this. But the bottom line is if you have more distribution for your fund, you’re able to gain economies of scale. You reduce, for example, the cost and expenses of running the fund over a wider base, and that’s beneficial to all shareholders. It’s what I’ll call the mutualization of the mutual fund.
Peter Shea
We have noticed over the years that, and this has been noticed by other industry participants including the stock exchanges as well as distributors of intermediaries who are distributing fund shares as well as sponsors of ETFs, that ETFs are widely adopted by the younger generation of investors. And the mutual fund shares, mutual funds themselves, are really something that the older generation investors are keenly interested in maintaining. And so there is a generational or demographic aspect to this, and consequently a lot of sponsors of these products are thinking well, where do we want to be in twenty years given the demographics? So the adoption of ETF share classes is part and parcel of this positioning investment, pooled investment vehicles available to retail investors. As Paul says, the widest possible audience. In a certain regard, the ETF share classes are very appealing to what we call taxable investors: investors who are not tax exempt. There’s a great deal of tax efficiency the way ETFs operate, when portfolio managers want to rejigger a ETF portfolio they would engage in in-kind transactions through what we call custom baskets. In other words, instead of taking a proportionate slice of the portfolio, there’s a slice of the portfolio where they’re trying to move out what we call low basis cost taxable securities positions, moving them out of the portfolio and getting current or higher taxable base in return. So we see this tax management portfolio is very appealing to taxable investors. The tax exempt investors are, principally what I’m talking about here are the ones who are in pensions and retirement saving programmes, and the tax code in the US is very generous to those people by not taxing their income if they put them into these programmes. And consequently, those programmes tend to be run by centralised pension or retirement programme administrators who just aren’t equipped or unwilling to become equipped to deal with throughout the trading day, buying and selling of ETF shares. They want to do mutual funds. Administratively, it’s easier for them to do mutual fund transactions because that’s done only at four o’clock every afternoon in the US in the East Coast. So we’re seeing what could be a great sorting out because of the creation or the rising of ETF share classes where the mutual fund classes are very much geared towards tax exempt investor interest and the ETF share class is very much something that the taxable investor would really want to be part of.
Beverly Chandler
Does logic dictate that this move will encourage more younger investors into ETFs in the US?
Peter Shea
I would like to think that the move that will occur is going to occur anyway, that it’s already happening, and that this is what it’s really doing is it’s exposing that pool of investors who are already interested in ETF type trading to a larger pool of professional money managers who are very active and who have been doing this for years but have experienced a lot of tax drag and cash drag on the portfolios in the mutual fund format, or the mutual fund wrapper if you will, that they won’t experience now with the ETF wrapper. So it benefits both the portfolio management teams and their performance records and it also benefits the investors by exposing them to a larger pool of really good managers in this area.
Paul Miller
Yeah. And I’ll just add on that point, Peter references the professional managers. There’s definitely been a trend in the United States over the last twenty years to professional managed investment advisor, you know, people relying on advisors in order to marshal them through their generational decisions, investment decisions and the like. And advisors generally like the ETF structure because it permits them to, when they decide to make a decision to sell for example, they can go in the market and sell the shares as opposed to putting an order in at, you know, nine thirty in the morning or eleven or whatever and waiting till four o’clock to get the pricing. And of course events of the day can change, and you’ve got the order in. There’s just a lot more flexibility with the ETF structure and so you know, adding it to a mutual fund has that added benefit that advisors can use that structure for their managed accounts and we’re seeing that.
Beverly Chandler
And would this new regulatory change, would it apply to all ETFs?
Paul Miller
The way I would look at this, this is a request by existing mutual funds or mutual fund organisations to add an ETF. They may have standalone ETFs apart from the ETF share class, but they have experience with the ETF in that way, and now they want to add this distribution channel, if you will, to all of their existing or a large number of their existing mutual funds in order to take advantage of the things that we’ve talked about: the tax management, the portfolio management capabilities that come with the ETF structure, as well as appealing to that set of investors that prefer the ETF structure and the ability to look at what’s in the portfolio daily to be able to trade it daily to get the tax efficiency of it. So it’s kind of adding a sprinkle to the cone of ice cream where there’s already sprinkles on it. As an analogy from your previous ETF podcast.
Beverly Chandler
I’ve couple of years ago I was writing a lot about mutual fund to ETF conversions. How is this going to impact that? Is that yesterday’s news?
Peter Shea
Not really I think. There’s one thing that’s very interesting about the rise of an ETF share class. It makes the conversion process so much easier if you want to do it. Because now it’s just merely a board decision to create an ETF share class. Now Paul is going to get into which way you can exchange which class shares for their class, but if you have basically a mutual fund with a lot of tax and taxable investors, you basically could create the ETF share class, migrate them all into the ETF share class, and then shut down the mutual fund class. You’ve essentially done the conversion, but it’s done tax free as you would hope it would be tax free in a conversion process directly, but it solves a lot of problems in terms of the mechanics of dealing with that. There may be other issues, of course, in terms of if the manager, in conversions we have to confront these things where the manager is trying to a) avoid the shareholder vote, b) wants to make sure that it’s tax free to the investors, and c) wants to make sure his portfolio is portable. So, you know, there’s a bunch of hoops you have to jump through to make sure all that happens. And it can be done, but at the same time it does involve a lot of finessing. It may involve additional cost in terms of dealing with your broker-dealers, dealing with transfer agents and whatnot, that hopefully you can avoid that by having ETF share class to complete basically the conversion process.
Paul Miller
Yeah. And I’ll just add that you know, we’re not to the finish line on the ETF share class yet. While the SEC has indicated and it’s asked applicants to conform to a certain model now, and there’s additional requirements related to that model around board approval, board consideration under Rule 18-f3, what boards have to do in order to make sure they’re the conflicts between the ETF share class and existing mutual funds are not material and disadvantage one class versus another; we’re not to the end of that road yet, we’re not to the end of the road from an intermediary perspective. Most funds these days, mutual funds, are sold through indirect channels through brokers, big platforms like Schwab, NFS and so on, as well as the larger bulge bracket broker-dealers and those intermediaries still have to grapple with how do we affect an exchange? How do we how do we go from where we are today with the mutual fund and all the shareholder servicing and the distribution arrangements we have in place, how do we go from that to adding in this ETF share class? And the intermediaries are asking, well, what’s it going to cost from our perspective? So we’re not to the end of the road yet, so just to go back to your question. I don’t think conversions are going away anytime soon because we’re not to the end of that road yet. The plumbing hasn’t been settled and established for the ETF share class, and then the economics from an intermediary perspective have not been settled yet. Now, I’m sure there will be resolutions to the both of those issues in the coming months but its still up in the air and conversion still makes sense for certain types of structures. You know, for whatever reason, I think asset managers will look at it and consider do we want to tack on an ETF share class to an existing mutual fund or would this product would this strategy be better in a strict ETF format? And they have to grapple with that. They’re going to have to present that to the boards. They’re going to have to convince boards that one versus the other is the appropriate way, so we’re not quite there yet.
Peter Shea
We’ve seen issues with distribution of what we call intermediaries, like the broker-dealer wirehouses, like Morgan Stanley platforms, the Schwab platforms; where the wirehouses with say a manager has a mutual fund and they clone the strategy, and they create an ETF using the same strategy and now they try to run both, there’s an ETF and a mutual fund running the same strategy. We’ve seen a resistance from wirehouses, from sponsoring both of those products simultaneously or individually, because recently in the United States Regulation BI was put into effect. And that imposed a fiduciary duty – a certain lightly burdening fiduciary, but fiduciary duty nonetheless, between broker-dealers and their customers in terms of getting the best price and not self dealing. Not with a conflict of interest, and so not so much mitigating but eliminating conflicts of interest is how some firms are interpreting that. And so if you have a mutual fund share class that prices only at four o’clock today, the next four o’clock pricing, versus an ETF class that’s pricing throughout the day at market prices; first of all, you have a basic issue of well now you’ve got two different prices for the same fund. You know when there was cloned, they had this objection. How do we determine what’s the best price to offer our customers? So there’s hasn’t seen resistance to that. We’ve known situations where people have had their mutual funds removed from platforms because they created a cloned ETF. And they don’t want to bother with either of it. They don’t want to go through that exercise. So we’ve seen that. So now we have ETF share classes, it’s the same fund, it becomes even more acute. And not only that, but you also have the situation where there’s additional expenses potentially to a mutual fund class that are absent or less than what you see in the ETF class. Where you would have for mutual funds you often see for instance, Class A Shares, a front-end sales load, what we call a 12b-1 fee, which is this is accruing annual payment due to the broker for the amount of shares that their customers maintain in the fund. Things like that. You don’t experience those types of loads, those type of expenses with ETFs. So again, that’s where the conflict comes in, because if the client is eligible to invest in ETF share classes, why would you put them into a mutual fund class where they’re paying a front-end load that benefits the broker? That’s the conflict. That’s where regulation BI directly comes in. During the first Trump administration under Jay Clayton, the SEC engaged in a sweep of the broker-dealer industry for share class abuse, where investors who are eligible for say the institutional class shares where there’s no loads or minimal loads, instead they were putting them into a high load class. And so they had a number of cases that came out of that and that sort of like put a real teeth into this issue for the broker-dealer, the wirehouses, the intermediaries here. To a certain extent, some sponsors I’ve been talking to, clients as well, are saying, well, if we do this share class thing it looks like we’re going to be locked into selling only to financial advisors and registered investment advisors. Because that’s the only channel that would be available to us, because the wirehouses, the broker-dealer communities, the intermediaries, they can’t get paid, a) they don’t like that, and b) they have this regulatory issue coming up under Reg BI. Paul, you might want to talk about how there’s been some studies done on how much money they could stand to lose if we have share classes and it becomes rampant.
Paul Miller
Yeah. I mean, there’s been a recent survey that’s been put out that kind of alludes to the cost to the intermediaries of adopting or utilising the ETF share class. You know, intermediaries get paid to help. The way mutual funds work, is that if your shares are held at a broker, then that broker does certain amount of shareholder servicing, you know, they provide account statements, they answer questions about the fund shares and they do things of that sort. And then they also are involved in offering the shares to their customers. The mutual funds and the mutual fund sponsors pay the intermediaries for those services. With an ETF and an ETF share class, those services are all externalised. It’s traded like an operating issuer security on an exchange where you pay a brokerage commission to buy or sell the shares. And so it’s externalised from the fund itself. So that’s the economic difference and the impact on intermediaries is likely to be substantial absent some, you know, form of revenue sharing or other mechanism that can be introduced or, you know, will be introduced in connection with the ETFs and ETF share class. And then you have, with an ETF share class you have that within the mutual fund. And then if you start introducing that in the ETF share class context, what do you do with the stand alone ETFs? They’re going to have to keep that somewhat comparable for all the reasons that Peter alluded to.
Beverly Chandler
This is interesting times for the industry in the US, this is going to be a much more fundamental change than it first appeared, perhaps. Do you have any time frame? Do you have any idea when this will move forward?
Paul Miller
Well, again, from the SEC’s perspective, I think we’re talking about this year. They are pushing again, you know there might be another round of comments that get incorporated into the what I’ll call the model application, and existing applicants will be asked to conform to that model again. The next step after that would be a notice of hearing which is put out to let interested parties comment on the application and then there might be some comments in connection with that in that process. But ultimately I think the Commission strictly under the acting, the former acting chairman indicated they’re ready to move forward with this. So I think there’s from the SEC regulatory perspective, it’s somewhat imminent, it’s all the other background, the intermediary, again, those issues are have yet to be worked out. So we might get SEC approval, but you know as far as the launch of another ETF share class outside of Vanguard, that might be the end of the year, next year before we get to it.
Peter Shea
As Paul mentioned before, there’s you get over the SEC hurdle, but now you have to get through the boards to get the approvals for these classes. And then beyond that in the justifications for the classes and the and the policies, procedures that protect the shareholders of all classes. Beyond that, you have the plumbing, the administrative plumbing issue, which is, you know, how do you handle share exchanges? If you have two transfer agents, one for the mutual funds and one for the ETFs how does that work? How does the in-kind system work? And how do you balance out differential tax effects between creations of shares and redemptions of shares that can occur through either share class? And then you get to the distribution issues that have to be figured out before this all launches. I mean, you mentioned before about mutual fund ETF conversions, ETF share classes for mutual funds. There’s a big component here that a lot of people don’t appreciate and one is to that you have to have a sales plan, a distribution plan, a plan of distribution, how are you going to sell ETF shares? They’re sold very differently as we’ve been telling you about than mutual fund shares, where the mutual funds have all these incentives, these fees and loads that incentivize the broker-dealer community to sell them. So how do you sell the ETF shares? And a lot of people who have been in the mutual fund industry for a long time that don’t have the ETF distribution experience really need to think about that. That’s how you get a successful ETF share class. So just the way you get a successful ETF conversion.
Beverly Chandler
Sounds to me like there’s going to be another podcast, at least one more, if not two more; once this regulation has actually passed we’ll be back discussing how it can actually work. Thank you to my guests today, Peter Shea and Paul Miller of Seward and Kissel. And thank you to you for listening. Remember to subscribe and leave a review and feel free to contact us at podcast@chandlerpublishing.com. This has been an Off the Record recording from the ETF Express in partnership with Seward and Kissel LLP.
Outro
Off the Record is brought to you by ETF Express. Production by Imogen Rostron and Lisa Hynes and music by Otto Balfour. Thank you to our guests on this episode of Off the Record from ETF Express, and to you for listening. We look forward to you joining us next time.
Hello, my name is Beverly Chandler and I welcome you to our latest Off the Record podcast for ETF Express. I’m here with Peter Shea and Paul Miller of Seward and Kissel LLP, to discuss the expected arrival of ETFs as a share class in the US. Welcome gentlemen and first of all, let me ask you to introduce yourselves. Paul, do you want to go first?
Paul Miller
Certainly. Thanks for having us, Beverly. We really appreciate it. I’m Paul Miller. I’m a partner in the Investment Management Group at Seward and Kissel. I focus on registered funds, ETFs and registered adviser matters here in the US.
Beverly Chandler
And then Peter, would you like to introduce yourself?
Peter Shea
Certainly, Beverly, thank you for having us. I’m a partner in the New York Office of Seward and Kissel in Investment Management and I’ve been specialising in ETFs as well as other exchange traded products for many years now and work with a variety of regulated funds.
Beverly Chandler
And so we’re here to discuss this whole new phenomenon in America – ETFs as a share class. I don’t know which one of you wants to go first, but you could tell me what are ETFs as a share class?
Peter Shea
ETFs traditionally understood in the United States are basically a single fund of a single share class. Mutual funds, again it’s a single fund, but it can have multiple share classes. And the multiple share classes are differentiated by having different expenses, sales expenses, administrative expenses and things like that. What they cannot have is different advisor fees. So every share class of a mutual fund has to have the same advisory fee. Since about 2001 or so, Vanguard has had a ETF share class appended to mutual funds and that was granted approval by the SEC, principally on the basis that the ETF share class in the US has certain tax benefits that the mutual funds don’t enjoy; that the tax benefits in the ETF share class would actually in fact be a benefit to the mutual funds by being able to manage for positive tax consequences in the total funds portfolio by using what we an call in-kind exchange mechanism where ETF shares are created in-kind. Shares for a basket of securities or, you know, in redeeming they do the same thing in redemption in reverse, they take in shares of the ETF class and then they would issue out a deposit back basket of securities. Paul, you want to get to where we’ve gotten to now?
Paul Miller
Sure. And Vanguard was granted a patent in the early days which expired in 2023, and since the issuance of the order to Vanguard there has been adoption of Rule 6c-11 in the United States, which basically set the standard for what is required to launch an ETF in the US. And at the time of the adoption of 6c-11, which has really been a boon to the investment management industry in a way because you no longer have to wait for the SEC to issue an order to issue shares of an ETF. At the time of that rule adoption they determined not to permit – or adopt as part of the rule – the ETF share class as a part of a mutual fund. And so with the adoption of 6c-11 and now with the expiration of the Vanguard patent, it’s become an opportunity for other investment management firms, asset management organisations, to tack on if you will an ETF share class to their existing mutual funds. And there are benefits to doing so, which we’ll touch on. There was the rush to seek exemptive relief from the SEC, which is what’s required to offer this ETF share class as part of a mutual fund. Started at the expiration of the Vanguard patent, with the perpetual filing. Since that in 2023 there have been about 50 other asset managers and funds that have filed for such relief. That process was grinding along until really the change in administrations here in the US, the SEC was in the process and the staff was in the process of asking questions of the applicants. What are the risks to existing shareholders of having an ETF share class? What are the benefits? What are the disadvantages? They were pursuing that and then with the change in administration, it’s become clear that the SEC is ready to move on the relief that’s been out there now for a couple of years. And so they’ve asked applicants to take a look at their application. They’ve provided comments to one applicant in particular who’s since amended their filing, their exemptive application filing, and the staff has now asked remaining applicants to conform, if they’re interested in moving forward, their filings to the model that they provided. So that’s where we stand today. It looks like it’s on the immediate horizon, which I think many are excited about, at least on the investment management side of things.
Peter Shea
One other thing going on is a couple of the applications that Paul’s been talking about deal with ETFs getting mutual fund share classes. So there’s a reverse process being pursued in parallel here for those kinds of situations as well.
Beverly Chandler
So this interests me as to why would either want to do these things, so why would a mutual fund want to have an ETF share class? And why would an ETF want to have a mutual fund share class? What advantages do either of those structures bring?
Paul Miller
At the end of the day, it’s about distribution and making your shares available to the widest audience available, and so you have investors that have now been exposed to ETFs for a number of years and have become comfortable with it, you know, and I’ll let Peter speak to some of maybe the generational aspects of this. But the bottom line is if you have more distribution for your fund, you’re able to gain economies of scale. You reduce, for example, the cost and expenses of running the fund over a wider base, and that’s beneficial to all shareholders. It’s what I’ll call the mutualization of the mutual fund.
Peter Shea
We have noticed over the years that, and this has been noticed by other industry participants including the stock exchanges as well as distributors of intermediaries who are distributing fund shares as well as sponsors of ETFs, that ETFs are widely adopted by the younger generation of investors. And the mutual fund shares, mutual funds themselves, are really something that the older generation investors are keenly interested in maintaining. And so there is a generational or demographic aspect to this, and consequently a lot of sponsors of these products are thinking well, where do we want to be in twenty years given the demographics? So the adoption of ETF share classes is part and parcel of this positioning investment, pooled investment vehicles available to retail investors. As Paul says, the widest possible audience. In a certain regard, the ETF share classes are very appealing to what we call taxable investors: investors who are not tax exempt. There’s a great deal of tax efficiency the way ETFs operate, when portfolio managers want to rejigger a ETF portfolio they would engage in in-kind transactions through what we call custom baskets. In other words, instead of taking a proportionate slice of the portfolio, there’s a slice of the portfolio where they’re trying to move out what we call low basis cost taxable securities positions, moving them out of the portfolio and getting current or higher taxable base in return. So we see this tax management portfolio is very appealing to taxable investors. The tax exempt investors are, principally what I’m talking about here are the ones who are in pensions and retirement saving programmes, and the tax code in the US is very generous to those people by not taxing their income if they put them into these programmes. And consequently, those programmes tend to be run by centralised pension or retirement programme administrators who just aren’t equipped or unwilling to become equipped to deal with throughout the trading day, buying and selling of ETF shares. They want to do mutual funds. Administratively, it’s easier for them to do mutual fund transactions because that’s done only at four o’clock every afternoon in the US in the East Coast. So we’re seeing what could be a great sorting out because of the creation or the rising of ETF share classes where the mutual fund classes are very much geared towards tax exempt investor interest and the ETF share class is very much something that the taxable investor would really want to be part of.
Beverly Chandler
Does logic dictate that this move will encourage more younger investors into ETFs in the US?
Peter Shea
I would like to think that the move that will occur is going to occur anyway, that it’s already happening, and that this is what it’s really doing is it’s exposing that pool of investors who are already interested in ETF type trading to a larger pool of professional money managers who are very active and who have been doing this for years but have experienced a lot of tax drag and cash drag on the portfolios in the mutual fund format, or the mutual fund wrapper if you will, that they won’t experience now with the ETF wrapper. So it benefits both the portfolio management teams and their performance records and it also benefits the investors by exposing them to a larger pool of really good managers in this area.
Paul Miller
Yeah. And I’ll just add on that point, Peter references the professional managers. There’s definitely been a trend in the United States over the last twenty years to professional managed investment advisor, you know, people relying on advisors in order to marshal them through their generational decisions, investment decisions and the like. And advisors generally like the ETF structure because it permits them to, when they decide to make a decision to sell for example, they can go in the market and sell the shares as opposed to putting an order in at, you know, nine thirty in the morning or eleven or whatever and waiting till four o’clock to get the pricing. And of course events of the day can change, and you’ve got the order in. There’s just a lot more flexibility with the ETF structure and so you know, adding it to a mutual fund has that added benefit that advisors can use that structure for their managed accounts and we’re seeing that.
Beverly Chandler
And would this new regulatory change, would it apply to all ETFs?
Paul Miller
The way I would look at this, this is a request by existing mutual funds or mutual fund organisations to add an ETF. They may have standalone ETFs apart from the ETF share class, but they have experience with the ETF in that way, and now they want to add this distribution channel, if you will, to all of their existing or a large number of their existing mutual funds in order to take advantage of the things that we’ve talked about: the tax management, the portfolio management capabilities that come with the ETF structure, as well as appealing to that set of investors that prefer the ETF structure and the ability to look at what’s in the portfolio daily to be able to trade it daily to get the tax efficiency of it. So it’s kind of adding a sprinkle to the cone of ice cream where there’s already sprinkles on it. As an analogy from your previous ETF podcast.
Beverly Chandler
I’ve couple of years ago I was writing a lot about mutual fund to ETF conversions. How is this going to impact that? Is that yesterday’s news?
Peter Shea
Not really I think. There’s one thing that’s very interesting about the rise of an ETF share class. It makes the conversion process so much easier if you want to do it. Because now it’s just merely a board decision to create an ETF share class. Now Paul is going to get into which way you can exchange which class shares for their class, but if you have basically a mutual fund with a lot of tax and taxable investors, you basically could create the ETF share class, migrate them all into the ETF share class, and then shut down the mutual fund class. You’ve essentially done the conversion, but it’s done tax free as you would hope it would be tax free in a conversion process directly, but it solves a lot of problems in terms of the mechanics of dealing with that. There may be other issues, of course, in terms of if the manager, in conversions we have to confront these things where the manager is trying to a) avoid the shareholder vote, b) wants to make sure that it’s tax free to the investors, and c) wants to make sure his portfolio is portable. So, you know, there’s a bunch of hoops you have to jump through to make sure all that happens. And it can be done, but at the same time it does involve a lot of finessing. It may involve additional cost in terms of dealing with your broker-dealers, dealing with transfer agents and whatnot, that hopefully you can avoid that by having ETF share class to complete basically the conversion process.
Paul Miller
Yeah. And I’ll just add that you know, we’re not to the finish line on the ETF share class yet. While the SEC has indicated and it’s asked applicants to conform to a certain model now, and there’s additional requirements related to that model around board approval, board consideration under Rule 18-f3, what boards have to do in order to make sure they’re the conflicts between the ETF share class and existing mutual funds are not material and disadvantage one class versus another; we’re not to the end of that road yet, we’re not to the end of the road from an intermediary perspective. Most funds these days, mutual funds, are sold through indirect channels through brokers, big platforms like Schwab, NFS and so on, as well as the larger bulge bracket broker-dealers and those intermediaries still have to grapple with how do we affect an exchange? How do we how do we go from where we are today with the mutual fund and all the shareholder servicing and the distribution arrangements we have in place, how do we go from that to adding in this ETF share class? And the intermediaries are asking, well, what’s it going to cost from our perspective? So we’re not to the end of the road yet, so just to go back to your question. I don’t think conversions are going away anytime soon because we’re not to the end of that road yet. The plumbing hasn’t been settled and established for the ETF share class, and then the economics from an intermediary perspective have not been settled yet. Now, I’m sure there will be resolutions to the both of those issues in the coming months but its still up in the air and conversion still makes sense for certain types of structures. You know, for whatever reason, I think asset managers will look at it and consider do we want to tack on an ETF share class to an existing mutual fund or would this product would this strategy be better in a strict ETF format? And they have to grapple with that. They’re going to have to present that to the boards. They’re going to have to convince boards that one versus the other is the appropriate way, so we’re not quite there yet.
Peter Shea
We’ve seen issues with distribution of what we call intermediaries, like the broker-dealer wirehouses, like Morgan Stanley platforms, the Schwab platforms; where the wirehouses with say a manager has a mutual fund and they clone the strategy, and they create an ETF using the same strategy and now they try to run both, there’s an ETF and a mutual fund running the same strategy. We’ve seen a resistance from wirehouses, from sponsoring both of those products simultaneously or individually, because recently in the United States Regulation BI was put into effect. And that imposed a fiduciary duty – a certain lightly burdening fiduciary, but fiduciary duty nonetheless, between broker-dealers and their customers in terms of getting the best price and not self dealing. Not with a conflict of interest, and so not so much mitigating but eliminating conflicts of interest is how some firms are interpreting that. And so if you have a mutual fund share class that prices only at four o’clock today, the next four o’clock pricing, versus an ETF class that’s pricing throughout the day at market prices; first of all, you have a basic issue of well now you’ve got two different prices for the same fund. You know when there was cloned, they had this objection. How do we determine what’s the best price to offer our customers? So there’s hasn’t seen resistance to that. We’ve known situations where people have had their mutual funds removed from platforms because they created a cloned ETF. And they don’t want to bother with either of it. They don’t want to go through that exercise. So we’ve seen that. So now we have ETF share classes, it’s the same fund, it becomes even more acute. And not only that, but you also have the situation where there’s additional expenses potentially to a mutual fund class that are absent or less than what you see in the ETF class. Where you would have for mutual funds you often see for instance, Class A Shares, a front-end sales load, what we call a 12b-1 fee, which is this is accruing annual payment due to the broker for the amount of shares that their customers maintain in the fund. Things like that. You don’t experience those types of loads, those type of expenses with ETFs. So again, that’s where the conflict comes in, because if the client is eligible to invest in ETF share classes, why would you put them into a mutual fund class where they’re paying a front-end load that benefits the broker? That’s the conflict. That’s where regulation BI directly comes in. During the first Trump administration under Jay Clayton, the SEC engaged in a sweep of the broker-dealer industry for share class abuse, where investors who are eligible for say the institutional class shares where there’s no loads or minimal loads, instead they were putting them into a high load class. And so they had a number of cases that came out of that and that sort of like put a real teeth into this issue for the broker-dealer, the wirehouses, the intermediaries here. To a certain extent, some sponsors I’ve been talking to, clients as well, are saying, well, if we do this share class thing it looks like we’re going to be locked into selling only to financial advisors and registered investment advisors. Because that’s the only channel that would be available to us, because the wirehouses, the broker-dealer communities, the intermediaries, they can’t get paid, a) they don’t like that, and b) they have this regulatory issue coming up under Reg BI. Paul, you might want to talk about how there’s been some studies done on how much money they could stand to lose if we have share classes and it becomes rampant.
Paul Miller
Yeah. I mean, there’s been a recent survey that’s been put out that kind of alludes to the cost to the intermediaries of adopting or utilising the ETF share class. You know, intermediaries get paid to help. The way mutual funds work, is that if your shares are held at a broker, then that broker does certain amount of shareholder servicing, you know, they provide account statements, they answer questions about the fund shares and they do things of that sort. And then they also are involved in offering the shares to their customers. The mutual funds and the mutual fund sponsors pay the intermediaries for those services. With an ETF and an ETF share class, those services are all externalised. It’s traded like an operating issuer security on an exchange where you pay a brokerage commission to buy or sell the shares. And so it’s externalised from the fund itself. So that’s the economic difference and the impact on intermediaries is likely to be substantial absent some, you know, form of revenue sharing or other mechanism that can be introduced or, you know, will be introduced in connection with the ETFs and ETF share class. And then you have, with an ETF share class you have that within the mutual fund. And then if you start introducing that in the ETF share class context, what do you do with the stand alone ETFs? They’re going to have to keep that somewhat comparable for all the reasons that Peter alluded to.
Beverly Chandler
This is interesting times for the industry in the US, this is going to be a much more fundamental change than it first appeared, perhaps. Do you have any time frame? Do you have any idea when this will move forward?
Paul Miller
Well, again, from the SEC’s perspective, I think we’re talking about this year. They are pushing again, you know there might be another round of comments that get incorporated into the what I’ll call the model application, and existing applicants will be asked to conform to that model again. The next step after that would be a notice of hearing which is put out to let interested parties comment on the application and then there might be some comments in connection with that in that process. But ultimately I think the Commission strictly under the acting, the former acting chairman indicated they’re ready to move forward with this. So I think there’s from the SEC regulatory perspective, it’s somewhat imminent, it’s all the other background, the intermediary, again, those issues are have yet to be worked out. So we might get SEC approval, but you know as far as the launch of another ETF share class outside of Vanguard, that might be the end of the year, next year before we get to it.
Peter Shea
As Paul mentioned before, there’s you get over the SEC hurdle, but now you have to get through the boards to get the approvals for these classes. And then beyond that in the justifications for the classes and the and the policies, procedures that protect the shareholders of all classes. Beyond that, you have the plumbing, the administrative plumbing issue, which is, you know, how do you handle share exchanges? If you have two transfer agents, one for the mutual funds and one for the ETFs how does that work? How does the in-kind system work? And how do you balance out differential tax effects between creations of shares and redemptions of shares that can occur through either share class? And then you get to the distribution issues that have to be figured out before this all launches. I mean, you mentioned before about mutual fund ETF conversions, ETF share classes for mutual funds. There’s a big component here that a lot of people don’t appreciate and one is to that you have to have a sales plan, a distribution plan, a plan of distribution, how are you going to sell ETF shares? They’re sold very differently as we’ve been telling you about than mutual fund shares, where the mutual funds have all these incentives, these fees and loads that incentivize the broker-dealer community to sell them. So how do you sell the ETF shares? And a lot of people who have been in the mutual fund industry for a long time that don’t have the ETF distribution experience really need to think about that. That’s how you get a successful ETF share class. So just the way you get a successful ETF conversion.
Beverly Chandler
Sounds to me like there’s going to be another podcast, at least one more, if not two more; once this regulation has actually passed we’ll be back discussing how it can actually work. Thank you to my guests today, Peter Shea and Paul Miller of Seward and Kissel. And thank you to you for listening. Remember to subscribe and leave a review and feel free to contact us at podcast@chandlerpublishing.com. This has been an Off the Record recording from the ETF Express in partnership with Seward and Kissel LLP.
Outro
Off the Record is brought to you by ETF Express. Production by Imogen Rostron and Lisa Hynes and music by Otto Balfour. Thank you to our guests on this episode of Off the Record from ETF Express, and to you for listening. We look forward to you joining us next time.
