Wall Street Firms Race to Launch Vanguard-Style ETFs Amid SEC Approval

Wall Street firms are rushing to launch Vanguard-style funds, raising concerns about the potential impact on the exchange-traded fund (ETF) market. The U.S. Securities and Exchange Commission (SEC) is expected to approve applications for dual-share class structures as early as this summer, allowing fund managers to add ETF shares to existing mutual funds. Over 50 companies, including BlackRock Inc. and State Street Corp., are awaiting regulatory approval to deploy this hybrid structure, which became possible after Vanguard Group Inc.'s exclusive patent expired two years ago.

This dual-share class model is highly attractive to asset management companies looking to enter the ETF market on a large scale without starting from scratch. It also provides a lifeline for companies that have suffered from mutual fund outflows as investors shift to more tax-efficient alternatives. Historically, this structure has helped Vanguard save its clients tens of billions of dollars in taxes over the past two decades.

However, replicating this model may be more challenging than it appears. Some Wall Street experts warn that this change could erode the key advantages of ETFs, particularly when hybrid funds face large-scale redemptions under market pressure. The core concern revolves around the tax mechanisms that ETFs are designed to avoid. Due to the in-kind redemption process, these funds rarely pay capital gains taxes, as it allows issuers to exchange securities with authorized participants rather than selling them directly.

In contrast, mutual funds redeem in cash, meaning managers may need to sell securities to meet redemption demands. If these sales generate capital gains, they may be distributed to investors. In hybrid funds, these taxable gains could also be passed on to ETF shareholders. For mutual funds with zero net inflows or outflows, this may not be an issue. However, for funds experiencing outflows, ETF shareholders could face risks. Historical examples, such as a Vanguard fund that distributed 14% of capital gains to both share classes after a large-scale redemption in 2009, highlight the financial complexities that can arise when funds share investment portfolios and experience significant outflows.

Brokerage firms that provide fund lists to financial advisors, such as UBS Group Inc., are studying how this will affect the types of funds offered on their platforms. UBS's Mustafa Osman, who is responsible for due diligence in evaluating whether funds should be added to the platform, noted that ETF share classes may face the risk of accepting tax distributions that they would not otherwise have. The SEC refers to this issue as "cross-subsidization" and requires applicants to detail how they will mitigate this problem. In response, companies like Dimensional Fund Advisors have modified their applications to outline management structures, including collaboration with independent boards of directors to assess the benefits of dual-share structures for both types of shareholders and monitor cross-subsidization risks before and after issuance.

Another complex factor is how this structure will affect the economic model of ETF listings on well-known platforms. If mutual fund assets are significantly shifted to ETF share classes, brokerage firms and trading platforms could lose up to 30 billion dollars in revenue. To curb revenue loss, intermediaries may start signing revenue-sharing agreements with ETF issuers, which could ultimately increase investor costs. Over the past few years, there has been a trend in the ETF sector to try to recoup some of the income gradually lost from mutual funds.

In addition to cost and tax advantages, ETFs are known for their higher liquidity compared to mutual funds. If these two models are combined, this selling point could be weakened in certain situations. ETFs that struggle to scale may experience wider bid-ask spreads, ultimately passing on the costs to investors. Overall, this is uncharted territory. Vanguard's success has relied on stable cash flows, deep relationships with market makers, and highly liquid investment portfolios. Large companies may be able to replicate this success, but smaller managers with less liquid assets may find the path more challenging. It remains unclear whether authorized participants are prepared to handle a large number of small ETFs as share classes, especially outside the most liquid underlying markets.