Vanguard share class monopoly faces challenge with unique filing

A US investment boutique has filed with regulators to launch mutual fund share classes of its family of exchange traded funds in the latest attempt by the industry to break Vanguard’s lucrative US-wide monopoly on the innovative structure.

Vanguard was granted a US patent for its “ETF-as-a-share-class” structure in 2000, allowing it to operate a mutual fund and a sister ETF as essentially the same vehicle, generating superior tax efficiency and economies of scale.

It subsequently launched 70 multi-share class funds, which now have about $5tn of assets, helping power its rise to the world’s second-largest fund manager, after BlackRock.

Vanguard’s patent expired in May, prompting Dimensional Fund Advisors and PGIA, the US arm of Australian asset manager Perpetual, to file for exemptive relief from the US Securities and Exchange Commission to launch ETF share classes for some of their mutual funds.

However the SEC has yet to respond to these requests, reinforcing concerns that the regulator may have got cold feet about the umbrella structure in the years since giving Vanguard the green light.

F/m Investments, a Washington DC-based multi-boutique has now become the first asset manager to file for exemptive relief to move in the opposite direction — creating mutual fund share classes of its existing ETFs.

“While much of the discussion in the fund world recently has focused on mutual fund to ETF conversions, investors who primarily use mutual funds should not be ignored,” said Alexander Morris, president and chief investment officer of F/m.

“Investors stand to benefit immensely from this groundbreaking dual share class structure — adding mutual fund capability to a suite of ETFs.”

F/m’s filing comes just two weeks after US bond giant Pimco said it would seek approval from shareholders in nine of its Dublin-based ETFs to amend their articles of association to allow it the option to issue non-ETF share classes of the funds.

Ireland has already approved the ETF-as-a-share-class structures, with HSBC Asset Management launching ETF share classes of four bond mutual funds with combined assets of $6bn in May.

F/m is seeking regulatory approval to offer mutual fund share classes for its Benchmark Series range of single bond ETFs — which were itself groundbreaking as the first such products in the world when they debuted on the Nasdaq exchange in August 2022.

The 10-strong range, which each offer exposure to the most current US Treasury bill or bond in tenors ranging from three months to 30 years, have since raised $2.2bn of assets, according to the filing.

However F/m argues that the funds, like all ETFs, are largely off limits to investors saving for their retirement in 401(k) pension plans, a key market for bonds.  

“ETFs are generally excluded from the approximately $6.6tn 401(k) marketplace primarily due to technology limitations of 401(k) record-keeping systems,” it said in the filing.

“Pension plans have to buy mutual funds, or it’s so much easier for them they don’t tend to bother to buy ETFs,” Morris told the FT.

However, even though the SEC granted Vanguard the right to operate structures with both an ETF and a mutual fund component, it is far from clear that it will let anyone else do the same.

In 2019 it flagged concerns over possible conflicts of interest between investors in different share classes of an umbrella structure.

One potential conflict arises from a mutual fund’s need to sell shares if it faces redemptions, incurring trading costs, while an ETF can instead hand a parcel of securities to an authorised participant, the market makers that act as middlemen for ETFs.

“An ETF share class that transacts with authorised participants on an in-kind basis and a mutual fund share class that transacts with shareholders on a cash basis may give rise to differing costs to the portfolio,” the SEC said in 2019.

“As a result, while certain of these costs may result from the features of one share class or another, all shareholders would generally bear these portfolio costs.”

Morris understood these concerns, noting that a mutual fund may have to hold more cash than a comparable ETF in order to meet redemptions. As a result, he did not believe that the groups that have applied to launch ETF share classes of existing mutual funds were likely to be successful.

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However he argued the simplistic nature of F/m’s Benchmark ETFs — with each holding one highly liquid Treasury bill or bond — meant it could satisfy the SEC’s concerns.

“Treasuries behave differently from a lot of securities. We can eliminate a lot of the frictional issues the SEC is worried about,” Morris said.

“We operate with cash equivalents. By offering the same fee rate on the mutual fund [0.15 per cent] we subsume the [additional] costs. [Investors will have] exactly the same fee and performance experience whatever class they are in,” he added.

Some questioned the rationale for launching a mutual fund share class of an ETF, though, even if it is approved.

“To me it makes no sense whatsoever. The mutual fund wrapper is less tax efficient in the US than the ETF wrapper, and all the flows are going into ETFs. You are swimming against the currents,” said Michael O’Riordan, founding partner of consultancy Blackwater Search and Advisory.

F/m said it had also filed a provisional patent application in the event it was successful.