As was recently noted in this space, Dimensional Fund Advisors (DFA) last broke new ground in the world of exchange traded funds (ETFs) when it became the first issuer since Vanguard to launch an ETF share class of an established index or mutual fund.
DFA generated some ETF industry history with the launch of the DFA US Micro Cap ETF (NYSE: DFMC). With any luck on the regulatory front, DFMC will be followed by another dozen DFA ETF share classes and potentially hundreds more from other issues because more than 90 have requested regulatory approval for this form of ETF.
The door is wide open for more ETF share classes to come to market because Vanguard’s patent on that structure expired in 2023. There’s no arguing that was beneficial to Vanguard as the issuer is now the second-largest in ETF terms in the U.S. That’s not to say other issuers will follow similar trajectories when they’re approved for ETF share classes, but asset growth is a possibility because the audience for ETF share classes is broad.
Broad Appeal for ETF Share Classes
It’s not that ETF share classes are “better” than ETFs born the traditional way. They’re not, but as is the case with standard ETFs, share class ETFs have broad appeal and much of that boils down to the ETF structure itself.
As Jon Maier of J.P. Morgan Asset Management points out, ETF share classes may well find an audience among mutual fund investors because due to the in-kind creation and redemption process, ETFs of all stripes offer tax benefits not accessible to mutual funds. For issuers, there’s the added perk of bringing ETFs to market that are related to mutual funds with which advisors and investors are familiar.
For the issuers that can leverage that scenario, it may be more appealing than simply launching new ETFs the old fashioned way. Separately, ETF investors can also glean benefits from tapping into ETF share classes.
Those investors “gain access to established strategies with proven track records and greater scale, as the share class leverages the history and assets of an existing mutual fund,” notes Maier.
Of course, issuers themselves stand to benefit because they’re not capitalizing on established products while avoiding the burden of launching from-the-ground-up ETFs, they’re also positioning themselves to win as the union of active management and ETFs grows.
ETF Share Classes Present Challenges, Too
Broadly speaking, ETF share classes are good things for advisors, clients and issuers, but there are some operational challenges. Those include the concept of exchange privilege, which as Maier notes, is subjected to some antiquated plumbing.
“Fund administrators must restructure accounting and compliance systems and automate exchanges,” he says. “While many distributors may initially hesitate to build out these capabilities, there may be a domino effect: once a few key players establish a footprint, others could follow. Simultaneously, custodians must modernize their systems to handle daily portfolio transparency requirements and the complexities of transactions across share classes.”
Then there’s the issue – it’s a big one at that – of ensuring fund boards are doing right by all of their investors – mutual fund and ETF share class.
“None s more critical than ensuring equitable treatment for all shareholders as more firms adopt the ETF share class structure,” concludes Maier. “Fund boards have the fiduciary responsibility of determining that the dual-class structure serves the best interests of each share class (mutual fund and ETF shareholders)and the fund as a whole.”
Related: Why Low-Volume ETFs Could Be the Smartest Trade You’re Not Making