While these share classes exist in multiple jurisdictions around the globe, in the US they have been limited to one fund sponsor (Vanguard) offering ETF classes of passive index mutual funds.

That, however, is about to change.

When the patent for Vanguard’s ETF share class structure expired in May 2023, 62 fund managers (at the time of this writing) filed for regulatory approval to expand the structure to active management, semi-transparent active and the addition of a mutual fund class to an existing ETF.

This paper explores the main features of the filings, taking a more granular look into the exchange privilege, the benefits to all participants impacted and critical considerations for providers, custodians and the broader ETF ecosystem.
 

The SEC has prioritized ETF share class this year

In remarks at a March Investment Company Institute conference, then-acting Securities and Exchange Commission (SEC) chair Mark Uyeda said he had directed staff to prioritize review of ETF share class applications, leading to further discussion and expanded filings from fund managers. This activity has boosted optimism, shared by State Street’s ETF product team, that the US ETF industry could not only see an approval in the calendar year of 2025, but also an ETF class launch.

Key features and considerations of share class filings

The filings allow active fund managers to add an ETF class to an existing mutual fund. The expectation is that the fund will align with the standards set by ETF Rule 6c-11, approved in 2019, including full transparency, ability to utilize custom baskets and other website reporting requirements.

In addition, fund sponsors will be required to provide enhanced board oversight, reporting and disclosures. This board oversight may include firm-specific surveillance to board approved preset thresholds.

There are important considerations for a board prior to approving the structure, including:

• Impact of daily portfolio transparency
• Potential capacity constraints as ETFs are open-ended and cannot be closed to new investors
• Impact of ETF class capabilities (in-kind mechanism, exchange trading, cost benefits) to the overall fund and other classes
• Shareholder makeup and potential volume of initial shareholders participating in the exchange privilege
• Existing funds unrealized and realized tax position (special distributions should be considered to avoid the ETF having a realized tax position on day one)
• Potential for any cross-subsidization
• Frequency of enhanced board reporting and analysis of thresholds

Post-board approval and launch of the structure, ongoing board reporting will be required. Board reporting should include numerical, pre-approved thresholds, and describe how the fund and its classes performed against those thresholds.

Critical elements of board reporting include:

• Traditional ETF metrics
  • Distributor report including primary market volumes and activity
  • Investment advisor report on ETF trading including: Premium/discounts, bid/ask spreads, trading volumes, and detailed primary market activity specifically tied to custom basket usage and outcomes
• Exchange privilege volume and impact, if any
• Impact to cash drag in the mutual fund class as well as to the ETF class
• Impact to long- and short-term capital gains
• Performance differences among classes
• Negative impact of the operating model to either class
• Description of any threshold exceeded over the prior period

Boards will decide if there is the need for any actions associated with exceeding thresholds, although both board and advisor should consider a pre-determined list of potential remedial actions.