SEC fears may cement Vanguard monopoly
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Fears that some investors are cross subsidising others may prevent rival fund managers from being allowed to replicate a unique tax-efficient fund structure created by Vanguard.
Vanguard’s “exchange traded fund-as-a-share-class” structure allows the Pennsylvanian powerhouse to operate a mutual fund and a sister ETF as essentially the same vehicle, generating superior tax efficiency and economies of scale.
Vanguard’s patent for the structure expires next year, prompting speculation that rival fund groups might seek to replicate it.
However, despite allowing Vanguard to launch 70 multi-share class funds since 2001 with combined assets of $4.9tn, it is far from certain that the Securities and Exchange Commission, the regulator, will allow any other fund managers to follow suit.
“I think the SEC still has questions around the structure, which would need to be satisfied before we would see large-scale adoption,” said Barry Pershkow, partner at Chapman and Cutler, a finance industry-focused law firm.
“It doesn’t seem to me that the patent was the problem,” Pershkow added, given that Vanguard has in the past spoken to other fund groups about licensing arrangements. “The barrier to entry was the SEC staff. They have concerns about the class subsidisation.”
The SEC said in 2019 that it would not scrap its requirement that asset managers should first have to apply for “exemptive relief” from existing US mutual fund rules before launching a “share class ETF”, even though this stipulation was swept away for plain vanilla ETFs.
This ruling came despite Vanguard already having exemptive relief to launch any passive share class ETF it wished.
That the SEC was unwilling to liberalise its authorisation regime, despite the obvious impediment to a level playing field this created, suggested its concerns run deep.
These are centred on avoiding “conflicts of interest among a fund’s share classes” to ensure they “have the same rights and obligations as each other class”.
One potential conflict is that a mutual fund must sell shares if it faces redemptions, incurring trading costs, but 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.”
Pershkow believed that the SEC gave the green light for Vanguard “before the staff and the commission were savvy enough to really understand the implications of the structure”. The SEC declined to comment for this story.
The arrangement has provided clear tax deferral benefits for investors, however, due to a quirk in US capital gains tax regulations.
When mutual fund investors redeem, the sale of underlying holdings in a “cash” transaction potentially triggers a tax liability for all investors, even those not redeeming.
In contrast, the in-kind transactions that ETFs typically engage in means trading activity occurs outside of the fund so there is no tax “pass-through”.
By bolting together a mutual fund and an ETF, Vanguard is able to siphon securities that have appreciated out of the mutual fund into the ETF and dispose of them via an AP, so the tax liability is not triggered.
“That was the origin of the Vanguard plan. They started this because they had an awful lot of capital gains build up and thought ‘can we not kick it out?’” Pershkow said.
Widespread adoption of share class ETFs could also solve another issue for fund providers. In the past 18 months a handful of managers, headed by Dimensional Fund Advisors, have converted existing mutual funds into ETFs in order to tap into the latter’s rising popularity.
However, the expected rush of conversions has not unfolded. This wariness appears to be due, in part, to concerns that a changeover might drive away investors who prefer mutual funds. Adopting the Vanguard structure solves this problem by letting all investors choose their preferred share class.
Despite this, few managers may attempt to follow Vanguard’s lead.
“I don’t think we are going to see many pounce on the opportunity to replicate the Vanguard model,” said Ben Johnson, director of global ETF research at Morningstar.
Johnson believed most managers that might have been interested in doing so, such as T Rowe Price and Fidelity, had already launched ETF replicas of their mutual funds.
Moreover, “the potentially adverse tax leakage resulting from outflows from the mutual fund are enough to keep many from trying to utilise that structure”, he argued.
Johnson said Vanguard had held discussions in the past about licensing the structure to others, even reaching an agreement in 2015 with USAA, which ultimately decided to launch standalone ETFs instead.
“We have seen limited interest in the past in this structure,” Johnson said.
He believed it had worked well for Vanguard because the Pennsylvanian group has never “been plagued by capital outflows that might have triggered large tax losses”. Fund houses with jumpier investors might not fare so well.
Furthermore, while an ETF share class can potentially stem systemic outflows from a mutual fund complex, Johnson said any suggestion of superior tax efficiency was a “moot point” for managers whose distribution was primarily through tax-efficient retirement plans.
“Never say never, but based around the conversations I have had with people around the industry, I don’t think we are going to see a huge number of asset managers looking to replicate this structure,” Johnson added.
Aniket Ullal, head of ETF data and analytics at CFRA Financial, believed basic economics would dissuade many managers from following Vanguard’s lead.
“The fees on mutual funds on average are higher than on ETFs,” so managers risked “potentially losing a large chunk of revenues” if they adopted the structures and existing investors switched to the ETF class.
However, Pershkow said “several” asset managers were actively looking at aping Vanguard’s structure — if they can win over the SEC.