Arguably, exchange-traded funds (ETFs) have been the most important portfolio innovation of all time. These tradable baskets of stocks, bonds, and other assets have transformed the way investors of all sizes build and manage their portfolios. And while once simply passive vehicles, active ETFs have taken this advancement even further by adding the ability for investors to outperform and access new strategies easily.
The question for ETFs is what comes next?
The answer for the industry may come from the mutual fund industry. The next wave of ETF growth will come from ETF share class applications of existing mutual funds. Providing benefits to both issuers and investors, ETF share classes are predicted to be the hot new ticket for portfolios.
Vanguard’s Patent
For many investors — including some institutional ones — the inner workings of how ETFs operate remain a mystery. The simplistic answer is that ETFs have a dual market structure. The bulk of investors buy ETFs on the secondary market. If you want to buy five shares of the Vanguard S&P 500 ETF, you simply log onto your brokerage account and place the order. Just like any other stock, market markers help facilitate the trade, and another investor sells you the shares.
However, there is a second side to ETFS — authorized participants (APs) such as institutional investors, endowments, and investment banks. They can buy ETFs on the primary market or directly from sponsors. Here, these APs exchange cash or enough securities to ‘make’ a share of an ETF. Those shares are then placed in their accounts and on the secondary market.
The beauty is that this process works in reverse. When an AP goes to sell, they can receive shares in-kind, i.e. enough cash or the securities that make up an ETF. This is why ETFs are more tax-efficient than mutual funds.
Back in 2001, asset manager Vanguard saw this two-level playing field as an advantage for its shareholders. They filed a patent that allowed the firm to classify their ETFs as a share class of their mutual funds. This had two major effects. First, it allowed them to instantly create a multi-billion ETF suite. Secondly, it allowed them to help reduce taxes for their mutual fund shareholders.
Vanguard has used the patent for its mutual funds to use the in-kind creation/redemption mechanism in order to push capital gains into its ETF share class. The patent has worked beautifully. VFIAX — the mutual fund version of the Vanguard 500 Index Fund, or VOO — hasn’t paid a single capital gain since 2001. All the gains and taxes get pushed into the ETF, and then right out the door.
The Growth Begins
For two decades, this gave Vanguard an advantage in asset gathering and tax savings. But a few years ago, the patent expired, and the rest of the asset management industry saw this as an opportunity to bring the same benefits to their shareholders.
Since then, numerous asset managers have filed relief statements with the SEC asking to use the expired patent’s structure for their mutual funds. According to investment data and research from Cerulli, as well as its new Cerulli Edge – U.S. Product Development Edition research paper, 69% of polled ETF issuers stated that they either already have filed exemptive relief applications, plan to file for exemptive relief at a later date, or are considering a dual-share-class structure initiative. 1
Then, back in March of this year, asset manager DFA reported that it had had very “constructive” conversations with the SEC regarding its filings. At the same time, the agency has expressed that making a decision on the relief filings is a paramount concern.
With these two announcements in tow, analysts now predict that ETF share class approvals could be coming sooner rather than later. And that could be a huge boost to overall ETF growth.
It’s no secret that mutual funds have been dying a slow death compared to ETFs over the last few decades. Thanks to better tax efficiency, intraday tradability, and lower costs, mutual funds have continued to bleed assets with many investors choosing ETFs. The growth of active ETFs has exacerbated this fact. This chart from the Investment Company (ICI) shows that the number of new mutual funds hasn’t kept pace with the number of liquidated or merged funds.
Source: ICI
For many legacy asset managers, ETF share classes represent an opportunity to regain their momentum and halt asset erosion. ICI now reports that there is approximately $28 trillion in mutual fund assets as of the end of 2024. Not necessarily because of inflows, but general investment growth/returns.
By offering ETF share classes of these mutual funds, asset managers can instantly create ETF suites, prevent investors from fleeing their funds, and ultimately introduce some competition to the top five mega-managers, who have continued to pull away in terms of asset gathering.
Investors win too. This includes tax efficiency and reducing their gains liabilities as well as potentially having lower overall costs.
With so much assets at stake, the ETF share class could be a multi-trillion-dollar way for ETFs to grow over the next few years. Potentially overnight. With more than 50 issuers, including BlackRock, Fidelity, State Street, and Charles Schwab, now asking for patent relief, SEC approval could be a major growth engine for the structure.
Still Some Caveats
Nonetheless, some pundits have expressed that despite the potential for ETF share classes, growth may not be as great as the industry hopes. There are a lot of moving parts.
For one thing, Vanguard’s patent focused on index funds. Many of the proposed ETF share classes closely resemble active mutual funds and ETFs. That potentially could be a problem.
A mutual fund share class can potentially harm the tax efficiency of an ETF if its capital gains are too large to be swapped out via in-kind redemptions or if there are significant outflows from the fund. ETF capital gains are very rare, but they do happen- even at Vanguard. Back in 2009, and after a very large mutual fund withdrawal, Vanguard was forced to distribute a 14% capital gain across both share class types. Moreover, the complexity of ETFs and the assets they hold are starting to reduce some of the tax efficiency. Bloomberg data show that last year, roughly 5% of passive ETFs distributed capital gains, while 12% of active funds did. Those were the most since 2021 and 2022, respectively. Then there’s the fact that some pundits have pointed out that an investor switching from a mutual fund share class to an ETF share class can actually be a taxable event in some cases.
Secondly, ETFs require traction, assets, and trading volume to function efficiently. Converting a small fund that doesn’t trade enough shares would result in wide bid/ask spreads and eliminate many of the benefits of the conversion. Additionally, some managers prefer to close funds to prevent them from becoming too large in the first place, thereby avoiding bloating and reduced results.
Finally, many boutique and smaller asset managers who rely on fees may be in for a rude awakening if they convert or offer ETF share classes. ETFs equal low costs. The economics may not work for many asset managers.
ETF share classes of mutual funds have the potential to be a real game-changer for the industry, adding trillions of dollars in assets and helping investors reduce their tax burden. Ultimately, it’s the next growth engine for the vehicle. However, that growth may not be as parabolic as investors and pundits think or hope. There are still many caveats and points to consider.
Bottom Line
With the SEC getting serious about passing relief for ETF share classes, growth for the investment vehicle is at hand. Potentially trillions of dollars worth of ETFs will hit the market over the next few years. Ultimately, that’s a good thing for portfolios. However, the growth may be muted .
1 PlanAdviser (May 2025). Industry Anticipates SEC Approval of Dual Share Class ETF Offerings
