(Bloomberg) — A little-noticed SEC filing from Morgan Stanley last week has the potential to help shake up trillions of dollars in fund assets — and may even prove a bigger deal for Wall Street this year than the much-trumpeted arrival of Bitcoin ETFs.
The firm is the latest to seek to replicate a fund structure employed solely by Vanguard Group that gave the Jack Bogle-founded juggernaut a tax-minimizing edge over the industry for two decades.
Morgan Stanley wants permission to add an ETF share class to its existing mutual funds, joining a growing list of money managers who are looking to recreate the blueprint that’s still exclusive to Vanguard despite the May expiration of a patent that walled off copycats. The Securities and Exchange Commission has yet to approve the hybrid structure for other issuers, a move that would let them port the tax efficiency of exchange-traded funds onto potentially trillions of dollars of mutual fund assets.
“An approval from the SEC here — one, or maybe multiple — would be the biggest news of 2024, and frankly, probably one of the most meaningful events in the asset-management industry in any number of years,” said Ben Johnson, head of client solutions at Morningstar.
The filing comes as the rift between mutual fund outflows and ETF inflows continues to widen. Mutual funds bled roughly $656 billion in 2023, while ETFs raked in $578 billion, Investment Company Institute data compiled by Bloomberg show. The ETF industry’s $8.3 trillion in assets still pales in comparison to the more than $20 trillion US mutual fund market.
The fund design, where one share class of a mutual fund exists in the form of an ETF, helped Vanguard minimize taxes by using the ETF portion to effectively deflect taxable capital gains built up in the mutual funds.
Since the Malvern, Pennsylvania-based fund giant’s patent on the structure expired last May, six asset managers have filed applications to re-create the model. First Trust Holdings, the sixth-largest US ETF issuer, filed on Jan. 24, just days before Morgan Stanley.
The filing “adds the ability to potentially have a fund that fits better on a certain type of platform,” said Ryan Issakainen, a senior vice president at First Trust. “So for example, think of some 401k and retirement accounts. There are ways that ETFs can make it on those platforms, but they’re more built for traditional mutual funds.”
Morgan Stanley declined to comment.
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Even though the SEC gave Vanguard permission to use the fund design more than two decades ago, there’s no guarantee it will allow others to do the same.
Regulators have since expressed concern about conflicts of interest between mutual fund and ETF investors, and in a sweeping overhaul of ETF rules in 2019 the watchdog deliberately retained the need for issuers to apply for an exemption if they wanted to pursue ETFs in a multiple-share class structure.
Meantime, while Vanguard was granted approval for the structure in passive form, its bid to apply it to actively managed funds years later didn’t win regulatory approval.
To Stacy Fuller, a partner at K&L Gates LLP, the SEC likely wants to finalize a proposal on so-called swing pricing — a liquidity mechanism based on a fund’s structure and objective — before acting on these applications.
“The swing-pricing rule would, according to the SEC, impose the costs of mutual fund purchases and redemptions on the investors behind them,” she wrote in an email. “This would largely eliminate the possibility of cross-subsidization by one fund class of another, which is what the SEC has cited as holding back its approval for multi-class ETFs.”
For now, the fund industry is left waiting for any word for the SEC — which isn’t obligated to respond to any of the approvals.
“We are hopeful the SEC will prioritize this area, which has the potential to confer substantial benefits to American investors,” said Gerard O’Reilly, co-chief executive officer and co-chief investment officer at Dimensional, which filed for the exemption in July and has more than $670 billion in assets.
“Many mutual funds have low brokerage costs, low levels of uninvested cash, and are tax-efficient, which make them good candidates for an ETF share class,” he added. “The ability to offer ETF share classes for such funds could enable more investor choice and the benefits of scale to all of the fund’s shareholders.”
