NYSE x ETF Central's ETF Education Series: Multi-Share Class ETFs

Trends in Active ETF Launches and Growth

Jeffrey Sardinha began by explaining that, in 2023, over 24 brand-new asset managers launched their first ETFs, reflecting the diversity of firms entering the market. These range from small SMAs looking to expand their distribution channels to large mutual fund managers who have yet to introduce ETFs.

Currently, Jeffrey notes that 36 or 37 of the top 50 active mutual fund managers either have proprietary ETF products or manage some for others, with more expected to enter the ETF space.

Further, Jeffrey believes that the trend towards active management in ETF launches is notable. He explains that many firms see opportunities in the active space, as there's a clear white space where top passive managers don't overlap with active managers. This shift is evident in the launch metrics and cash flows, with active ETFs drawing significant investor interest.

Douglas Yones added that more than 70% of ETFs launched in recent years have been active. For those seeking detailed data, he pointed out the free monthly report produced by the NYSE, which tracks these trends and is available on https://www.nyse.com/etfs.

Benjamin Slavin also highlighted the growing interest in actively managed ETFs, which now constitute around 8% of the industry but are capturing approximately one-third of the year's total ETF cash flow. This indicates that actively managed ETFs are punching above their weight class.

Initially, the focus of actively managed ETFs was on fixed income, but now equities are gaining traction, with a significant share of new product development in this area. Investor interest is diversifying, with money flowing into various types of actively managed products.

Low-cost active products, offered by issuers like Dimensional and Avantis, are particularly popular. Traditional high active share, concentrated equity portfolios, thematic products, and option-based strategies are also attracting significant investor attention.

Understanding Multi-Share Class ETFs

Tim Huver then explained the basic mechanics of multi-share class ETFs, highlighting how they function within a multi-share class registered investment company.

This structure, which was under patent by Vanguard until 2023, allowed ETFs to operate as a share class within an existing mutual fund portfolio. This approach generates immediate economies of scale, benefiting all investors across share classes.

One of the key advantages of this structure is the ability to reference the track record and performance history of the existing mutual fund portfolio. This provides a significant boost to the new ETF share class by leveraging established performance metrics. Additionally, tax efficiency is enhanced across all share classes within the portfolio, a benefit that is often overlooked but crucial for investors.

Tim also noted the improvement in liquidity for the ETF, particularly through the creation and redemption process. For example, in an aggregate bond index, the ETF can maintain an optimized portfolio and use cash flows from other share classes to manage liquidity, making it easier to track an index tightly, even with large, complex baskets of securities.

The ability to offer different funds and vehicles to meet the unique needs of shareholders is another significant advantage. This product-agnostic approach allows issuers to cater to various investor preferences and requirements.

Tim added that the expiration of the Vanguard patent opened the door for other firms to explore multi-share class ETFs.

The Journey to Multi-Share Class ETF Exemptive Relief

Morrison Warren explained the initial steps taken to explore exemptive relief for multi-share class ETFs. Perpetual approached Morrison and his team, asking if they believed obtaining exemptive relief was feasible.

Given the numerous benefits associated with the multi-class structure that Vanguard enjoyed, such as economies of scale and enhanced liquidity, the idea seemed promising.

At the time they started, the patent for the multi-share class structure still existed, but was nearing expiration. The team decided to approach the SEC to gauge their interest in granting exemptive relief. Initially, the response from the SEC staff was lukewarm, indicating a lack of enthusiasm for the topic at that moment.

Despite this, the group was undeterred and continued to pursue the idea, working with various stakeholders, including the NYSE, who could see the potential market benefits.

The team decided to apply, believing strongly in the benefits of this structure. Morrison noted that, despite the initial lack of encouragement from the SEC staff, there are now 14 applications filed for multi-share class ETFs. This reflects a growing recognition of the potential advantages among industry participants.

The SEC staff is currently providing comments on these applications, and applicants are working through these comments to address any concerns. While there is no set timeframe for approval, the increasing number of applications and ongoing discussions are encouraging signs of progress.

Managing Multi-Share Class ETFs: Insights from Global Custody Banks

Benjamin shared insights on managing multi-share class ETFs, highlighting that these structures are not uncommon outside the U.S. In fact, they are often the norm, particularly in Europe and other international markets. Multi-share class ETFs and mutual funds have been around for a long time, and BNY Mellon, along with other global custody banks, are well-versed in handling them.

From an operational perspective, managing multi-share class ETFs involves several critical components. These include custody, fund accounting, and ETF services. Investors must have a brokerage account, and switches between share classes require comprehensive instructions.

Since ETFs operate only in whole shares, decisions about residual cash must be made, and ETF service providers need to enrich these instructions, coordinating with brokerage accounts for share deliveries.

Operationally, several challenges and considerations must be addressed. These range from managing basket creations, where only part of the assets is impacted, to handling expense allocations, cut-off times, and underlying tax lots. These elements need to be meticulously managed to support the multi-share class structure effectively.

Benjamin emphasized that, while the foundational work for managing these structures is well-established, there are still unknowns, particularly regarding how the SEC will finalize the rules and requirements. The industry will need to automate and scale operations to accommodate the potential increase in ETFs if this structure becomes widely adopted.

Addressing SEC Concerns for Multi-Share Class ETFs

The discussion also highlighted several key concerns raised by the SEC regarding exemptive relief applications for multi-share class ETFs, focusing on potential tax impacts, expense allocation, cash management, and transparency.

Morrison noted that the primary issue is the potential tax impact. He said that the SEC is worried that the tax efficiency typically associated with ETFs might be compromised in a multi-share class structure. Ensuring equitable expense allocation between different share classes is another significant concern.

According to Morrison, the SEC wants to prevent any single class from being unfairly disadvantaged, which requires a robust allocation methodology and an appropriate operating model. Transparency is another issue, with concerns that the high level of transparency in ETFs might be lost when combined with mutual fund classes.

Cash management was another concern Morrison raised. There are questions about whether the mutual fund class would require more cash than typical for an ETF, potentially affecting liquidity and operational efficiency.

Finally, Benjamin added that another important consideration is the topic of conversions. Converting existing mutual funds to ETFs involves a lot of friction and behind-the-scenes work.

One of the goals of the multi-share class structure is to retain assets, especially those in retirement plans or qualified money. This structure offers an alternative to conversions, allowing investors to retain their assets while gaining the benefits of an ETF structure.

Overall, the panel noted that these challenges are considered solvable through collaborative efforts across the industry. Proper automation and scalability in operations, along with clear and transparent methodologies, will help in managing costs and maintaining the benefits of multi-share class ETFs.

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.