Rivals Pursue Vanguard’s Unique ETF Strategy

Susan Dziubinski: Vanguard’s patent on its unique hybrid mutual fund ETF structure expired in May 2023. There was a lot of speculation in the media at that time that a bunch of fund families were just going to bust through the door and try to adopt this strategy. And I seem to remember at the time, Dimensional Fund Advisors was actually trying to do that, that they were eager to offer ETF share classes of their funds. Talk a little bit about why this structure was unique to Vanguard for as long as it was, and why is it appealing for other asset managers?

Daniel Sotiroff: Well, you kind of alluded to it, right? It was patented, so you couldn’t actually do anything with it from a legal standpoint. But now that the patent is off, we’ve seen that there is some appetite out there. I think what’s going on right now is like, Dimensional has filed for it. There was another firm very early on called PGIA that filed for it for like six or seven of their mutual funds. And then Fidelity also filed a similar filing to Dimensional to also get that structure. The play there is, what happens is when you bolt the ETF share class onto an existing mutual fund, the mutual fund share classes inherit the tax advantages of the ETF. So, the ETF can purge those potential capital gains from the mutual fund share classes, and you get a potentially much more tax-efficient investment experience without having your investors have to actually sell out of the mutual fund and go into an ETF. So, active managers right now would be really interested in that because they’re losing money to more tax-efficient vehicles. So, this might be a way to protect some assets for them.

The tricky thing is, you’ve seen some appetite, but nobody is knocking down the door. The whole industry isn’t going after this. You do have to be careful about it because while there is that advantage of tax efficiency out there, it doesn’t really fit with every active manager. You can’t really shut down an ETF in order to, I guess, control your capacity. So, that’s long been an advantage of mutual funds. When managers seem to be taking in too much money and they start to lose their edge, they’ll shut the fund down. When you bolt on this ETF share class, that’s going to trade no matter what, and you can’t do that. So, it’s something that managers have to be very careful in assessing. So, that remains to be seen. And we should be clear: These haven’t been approved yet. These are just filings at this point. I think some of it is also we’re just testing the waters right now to see what the SEC thinks about this. And then, depending on what gets approved or disapproved with Dimensional and Fidelity and that other asset manager, we may see more or less depending on that outcome.

Dziubinski: If we’re talking about real-world implications for investors, if I own a mutual fund that would have this bolt-on ETF, it could be beneficial for me from a tax perspective, but maybe not if for some reason it’s a strategy where I might want my manager to shut the doors and manage the asset size, right?

Sotiroff: Correct, correct. Exactly. There’s give and take. There are benefits and disbenefits with it. So, the advantage you would get is definitely a more tax-efficient investment experience. You would have far fewer, if any, capital gains. But, again, if you’re in a very high-conviction strategy, it probably doesn’t make sense.

Watch the full conversation between Susan Dziubinski and Daniel Sotiroff in “What’s in Store for Vanguard’s Funds, ETFs, and More in 2024.”