Fidelity Wants to Offer ETF Share Classes for Active Mutual Funds  - What Could This Mean?

Setting the Stage: Understanding Vanguard's Pioneering Patent

Back in 2000, the SEC gave Vanguard a special permission. They allowed Vanguard to combine traditional mutual funds and a newer product, exchange-traded funds (or ETFs), under a single umbrella.

By 2003, this permission was broadened, letting Vanguard expand its offering to more types of stock funds, including those that focus on international stocks. Then, in 2007, Vanguard got another nod, this time to include bond funds in this dual-class structure.

Why is this so significant? These permissions, which are like 'golden tickets' from the SEC, paved the way for Vanguard to become a colossal force in the ETF world. They amassed over $2 trillion in assets just from their ETFs, making up almost 30% of the entire ETF market in the U.S. On the other side, their mutual funds, the traditional kind, also thrived with over $2.7 trillion in assets, buoyed by this dual structure.

However, by 2019, while the SEC was making general rules to govern ETFs, they decided not to continue allowing this dual-class structure under the new rules. Why?

They believed that the cost dynamics between the two classes - ETFs and mutual funds - could be different. This could mean, in some scenarios, one class might incur more expenses, but all investors, regardless of class, would end up sharing the bill.

So, they concluded that if any company wanted such a structure in the future, they'd have to apply for it, especially on a case-by-case basis ("exemptive relief").

Each application would be judged based on its own merits, ensuring the best interests of investors are always at the forefront. This is what Fidelity is attempting to do right now. 

What an Approval Means for Fidelity (and Others)

At present, Fidelity boasts a portfolio of 324 mutual funds. A whopping 262 of these, accounting for about 81%, are actively managed. This is a significant piece of information when considering the potential implications of the sought-after approval.

Should they receive the green light, Fidelity would have a clear path to emerge as a powerhouse in the active ETF realm.

The typical roadblocks associated with launching a new active strategy – such as establishing a track record, gaining brand recognition, and comprehensive research – would virtually disappear.

Fidelity's existing mutual funds already carry a historical performance and brand equity, which would enable them to swiftly ramp up their ETF offerings without starting from scratch.

However, Fidelity wouldn't be the only company to feel the ripple effect of such an approval. The decision would set a precedent, likely encouraging other big players in the mutual fund business to follow suit.

Charles Schwab, for instance, stands out as a notable contender. Schwab has already carved out a niche for itself with its current ETF offerings.

But, if given the opportunity, they would probably be eager to convert some of their actively managed mutual funds into ETF share classes. This would ensure they maintain pace with giants like Vanguard and Fidelity.

What an Approval Means for the Active ETF Space

An approval in favor of ETF share classes could bring a tidal wave of change to the world of actively managed ETFs.

With permission to transform portions of their mutual fund portfolios into ETFs, there's bound to be a surge in the number of active ETF offerings. And like any evolving marketplace, this expansion will bring about a series of ripple effects.

Let's begin with a basic economic principle: the relationship between supply and demand. As the number of active ETF offerings increases, competition will heat up, and fees are expected to decrease.

The Trackinsight 2023 ETF survey offers an insight that underscores this trend. It reveals that the main attraction for investors flocking to ETFs is their low fees.

With this prevailing sentiment among investors, ETF managers will undoubtedly feel the pressure to further reduce their expense ratios. This move will position these burgeoning ETFs to be even more financially competitive than their mutual fund equivalents.

Furthermore, the same survey paints a revealing picture of the investment community's preferences. In the Americas, 80% of respondents expressed a stronger inclination to invest in an active strategy if it's packaged as an ETF over a mutual fund.

With the potential widespread approval of the share class exemption, we might see a deceleration in the trend of mutual funds being converted into ETFs. Instead, managers may prioritize launching new ETF share classes to stay ahead in this competitive market.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.