The expected SEC approval of ETF share classes for mutual funds and vice versa poses more technical and tax-related challenges than simply pressing a button to convert massive holdings.
Dozens of asset management firms are waiting on the Securities and Exchange Commission to green-light the so-called dual share classes, also known as share-class relief. Approval will enable the companies to offer the same structure Vanguard pioneered in a patented design that expired two years ago. The firms applying to the Wall Street regulator for relief include rivals BlackRock, State Street, Dimensional Fund Advisors, JPMorgan Chase, Charles Schwab and T. Rowe Price.
Vanguard itself is asking the SEC to approve dual share classes in the firm’s actively managed strategies, even as a shareholder case over capital gains distributions that hit certain retirement investors in the firm’s target date funds is in flux due to a federal judge’s rejection last month of a $40 million settlement. Since avoidance of those capital gains and the taxes on them represents one of the main selling points for ETFs over mutual funds, the case highlights some of the looming questions for asset management firms, financial advisors and their clients if the SEC provides its long-anticipated blessing for dual classes.
There is “much more to it” than the fact that “investors like liquidity and they hate paying taxes,” said Alex Morris, CEO of F/m Investments, an investment management firm with $18 billion in client assets across its ETFs and other funds. The firm is seeking SEC approval for a mutual fund share class for one of its ETFs, which is the opposite direction of most of the filings aiming for an ETF version of mutual fund vehicles. Based on the timing of their applications and amendments in early April, F/m and Dimensional could be among the first to secure approval for dual share classes. Morris predicted that only a quarter or half of the more than 60 filers could address the operational, compliance and tax-related issues quickly enough to get their dual share classes up and running within a year of SEC approval.
“We’ve been working through this for a long time,” he said. “Practically, this seems very easy until you try it.”
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Hurry up and wait
Other experts have pointed to those concerns, alongside the potential for a shakeup of tens of billions of dollars in annual fees for brokerage firms tied to mutual funds and an alternative means of ETF conversion through increasingly popular Section 351 exchanges. The possibility of a tax hit from capital gains distributions in the course of assets moving from mutual funds into an ETF equivalent is raising some of the loudest alarms. And that’s only one aspect of the governance, ongoing monitoring and disclosure requirements that are likely to keep the boards and compliance teams of asset management firms — and their attorneys — busy in the transition, according to a whitepaper released earlier this month by law firm Ropes & Gray.
“While we anticipate that industry best practices will develop over time, at the outset there will likely be some trial and error and periodic recalibration may be necessary in order for funds to fully realize the benefits of the combined class structure,” the report said.
In addition to avoiding unanticipated capital gains distributions for ETF investors, the need to hold more cash or other liquid assets in order to offer both types of shares could raise the underlying fees. Based on the most recent form of amendments to Dimensional’s filings that the SEC has instructed other companies to follow, the relief could generate reams of reports explaining the technical, tax and other ramifications of dual classes of the same funds. An analysis of how many shareholders may face higher taxes as a result of the dual share classes will prove integral in the transition, according to the report.
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Vanguard TDF shareholder case update
Meanwhile, some of the complications of mutual funds and taxes are playing out in federal court. Last month U.S. District Judge John Murphy threw a wrench into Vanguard’s settlement with target-date investors, rejecting the civil settlement due to stipulations of the SEC’s enforcement order in January. In 2020, Vanguard slashed the minimum investment level in lower-cost institutional share classes of some of its target-date funds, which caused many retirement investors to migrate to those cheaper versions of the products. However, those who stayed wound up receiving much higher capital gains than usual, which drove up their taxes and reduced their compounding returns, SEC investigators said.
The regulator’s settlement order had called for restitution and fines of $106.4 million. One provision, though, held that the payouts were in addition to the amount that “Vanguard agreed to pay to settle an investor class action,” which would get added to the total “if the settlement is terminated or rejected,” the SEC’s announcement on the settlement stated. That’s what caused Murphy to toss the settlement in a May 19 ruling.
“If we approve, the harmed investors lose $13 million to attorneys’ fees,” Murphy wrote. “If we reject, the harmed investors get that $13 million themselves, through the SEC settlement (and could very well recover even more because this litigation will continue). As readers may have deduced, this is an unhappy situation for plaintiffs’ counsel, who only found out about the SEC settlement after it was publicly announced.
“Vanguard’s deal puts plaintiffs’ counsel in a difficult spot — how can they advocate for settlement if the class is better off rejecting it?” Murphy continued. “Notably, we didn’t find out about the SEC settlement (from plaintiffs or Vanguard) until a class member, John Hughes, brought it to our attention in a remarkable objection. He asks us to reject the proposed class settlement because, how can any settlement stand when it is guaranteed to net the class less money? A simple and compelling point. The named plaintiffs, their counsel and Vanguard cannot deny the math. But they adamantly, and creatively, dispute Mr. Hughes’s objection. After oral argument and additional rounds of briefing, we can safely conclude that the proposed settlement provides no value to the class and therefore reject it.”
In another ruling earlier this month, Murphy pushed back any outstanding filing deadlines to August, the completion of potential evidence discovery to mid-November and any motions for summary judgment to April 2026. Representatives for the SEC declined to comment on the ruling and case status beyond the regulator’s public filings, while those of Vanguard and the lawyers for the plaintiffs in the case didn’t respond to emails seeking comment.
READ MORE: How Vanguard’s tax-bomb target-date funds slammed wealthy investors
The upshot for advisors and investors
Regardless of what becomes of that case, it signals how investor expectations that ETFs will never bring any taxes from capital gains distributions may be creating a cycle in which issuers are “allowing the wrapper to decide things for you, and that feels kind of funky,” said Morris of F/m. It’s possible that there are some scenarios in which the capital gains represent, by and large, a better investment strategy for a majority of shareholders over the long term, he noted.
Beyond any investor cases, SEC approval of dual share classes could bring further headaches from setting up dual accounting systems to ensure that the ETF holders don’t get the tax hits and from working with any outside service firms to calculate the conversion of mutual fund shares that may extend to three or four decimal places to fully rounded ones on the other side.
Those types of considerations explain why the process “could get disorderly and messy quick,” said Morris. Advisors and other wealth management professionals should know that the shift will not occur overnight upon SEC approval, he added.
“The last thing you want to do is have a mutual fund you really like rush out a mutual fund-ETF share class,” Morris said. “One little error, one missed item today could eventually reverberate to be a big error, and I don’t want to see that happen.”
