Will Other Firms Adopt Vanguard’s Unique ETF/Mutual Fund Structure?

Vanguard’s exchange-traded funds have a structure unlike any other ETFs available today. Many are share classes of its popular mutual funds, not stand-alone ETFs. At the moment, this hybrid ETF/mutual fund is unique to Vanguard because it owns a patent on the structure.

The patent is set to expire in May 2023. As of this writing, one other asset-management firm has expressed an interest in adding an ETF share class to some of its existing mutual funds. On Feb. 7, Perpetual U.S. Services, on behalf of Australia-based PGIA, filed a document with the SEC to add the ETF share class to seven actively managed mutual funds under its Barrow Hanley brand. The filing has not been approved, but it shows that others are interested in bolting an ETF onto an existing mutual fund.

It’s not obvious that mutual funds will flock to the hybrid structure. Investors could benefit from a more tax-efficient share class. But adding an ETF share class may not immediately improve a mutual fund’s tax efficiency. And doing so would forfeit a feature of the mutual fund structure that some managers use to protect their edge.

Advantage Vanguard

Vanguard introduced its first ETF share class in late May 2001 when it launched Vanguard Total Stock Market ETF VTI—a share class of Vanguard Total Stock Market Index VTSAX. It has since introduced an ETF share class to dozens of additional mutual funds over the years, all of which track an index.

There are some clear advantages to the ETF-as-a-share class structure. Accessing the fund is easier and cheaper. Anyone with a brokerage account can buy or sell an ETF, and many of the largest brokerages no longer charge commissions for ETF trades.

Investors in the mutual fund share classes inherit a much bigger advantage. The ETF share class can purge stocks and bonds with built up capital gains through its in-kind redemption mechanism. That allows the ETF to track its target index throughout the day while cleansing its portfolio of potential capital gains distributions. The benefit extends to the stocks and bonds held by mutual fund share classes, and it’s part of the reason why Vanguard’s mutual funds with an ETF share class seldom distribute capital gains.

Likewise, the ETF and mutual fund share classes share the tax benefits when either sells depreciated stocks or bonds for a loss. Those losses can be held on the books as tax-loss carryforwards—a credit to the fund that allows it to offset realized capital gains in the future, further improving the tax efficiency of all share classes.

A Perfect Storm

Vanguard’s hybrid funds don’t just share the tax advantages, they also share any adverse tax consequences. Certain situations, often prompted by the actions of investors in the mutual fund, can leave investors in the ETF share class on the hook for capital gains distributions.

For example, Vanguard Extended Duration Treasury Index VEDTX had a capital gains distribution in 2009 that amounted to about 14% of the ETF share class’ year-end net asset value. Such a large distribution came by way of a rare combination of events. The prices of the Treasuries it held appreciated in late 2008, followed by considerable outflows from the mutual fund’s institutional share class in late 2008 and early 2009. Meanwhile, the ETF share class took in relatively modest flows that limited its ability to purge capital gains when it was most needed. That backed the mutual fund into a corner, forcing it to sell bonds that had appreciated in value to meet redemptions and creating realized capital gains in the process.

Such events have not occurred since, and the risk of a perfect storm repeating are relatively low—at least for Vanguard. Vanguard’s ETFs have been around for years if not decades. Many of them grew up with their mutual fund siblings and continue to take in new money, so they are considerably large and capable of handling potential capital gains distributions in most situations.

The circumstances surrounding Vanguard Extended Duration Treasury Index in 2009 hint at the mutual funds that are best suited to take on an ETF share class. Simply bolting an ETF onto an existing mutual fund with potential capital gains would expose ETF investors to their portion of those capital gains until the ETF is able to fully purge them. The ideal candidate would have built-up tax-loss carryforwards that allow it to manage redemptions while the ETF has some time to grow.

The Doors Are Always Open

Taxes aside, adding an ETF share class raises another issue concerning capacity management. Mutual funds have the option to close their doors to new investors as the fund grows and its ability to outperform its benchmark erodes. Adding an ETF share class forfeits that option because ETFs don’t possess a mechanism to prevent new money from entering. Instead, active managers will have to find other ways to put new money to work, such as investing in their second or third best ideas or wandering into segments of the market that they don’t usually venture.

This situation does not apply to most of Vanguard’s hybrid funds because they track broadly diversified indexes that hold hundreds if not thousands of stocks or bonds. They arguably have the ability to manage more money than most funds available in their respective categories. The chances that they will run into capacity issues are small, so they’re unlikely to shut their doors to new investors.

All of this points to a unique set of mutual funds that make for ideal candidates to add an ETF share class (if the SEC approves). Mutual funds with tax-loss carryforwards on their books and those not facing large and persistent outflows are in the best economic condition. Qualifying funds should also have room to handle enough money without damaging their edge.