While much of the financial media has been drawn to the bitcoin ETF race, another potentially bigger story is developing, which will have wider implications for large and small investors. We’re talking about the expiration of Vanguard’s patent to allow its ETFs to be share classes of its mutual funds.
That patent has allowed Vanguard’s shareholders some pretty hefty tax savings over the years and has helped cement its dominance in the ETF sector.
But that sheer dominance may be ending. Thanks to the expiry of its patent, numerous firms have started to step in and plan for similar ETF share classes of their funds. The ultimate winner will be investors, who now can save on capital gains taxes.
ETF Structure & Vanguard’s Patent
Exchange traded funds have exploded in popularity for a variety of reasons. But one of the biggest could be their tax efficiency. This comes from their structures. ETFs work because of their sort of dual nature.
You and I buy ETFs on the secondary market. However, authorized participants—institutional investors, endowments, and investment banks—can buy ETFs on the primary market. Here, they exchange cash or enough securities to ‘make’ a share of an ETF. Simplistically, it works like this: rather than holding all the stocks in the S&P 500, an institutional investor calls up State Street, hands them the stock, and State Street provides them with newly minted shares of the SPDR S&P 500 ETF Trust.
The reason why ETFs are more tax efficient than mutual funds has to do with the reverse of this process. Whatever selling happens in a mutual fund—whether that’s investors redeeming money or a manager booking profits—mutual funds pay out those capital gains and investors pay the taxes. Because of the primary market, when an authorized participant wants to exit the fund, they can be paid in-kind with all the shares of the underlying holdings. The same goes with active management and a manager wanting to sell a position. They can actually hand the shares over.
This is where Vanguard comes in.
Vanguard developed a patent in 2001 that allows them to classify their ETFs as a share class of their mutual funds. This was a stroke of luck as it allows Vanguard’s mutual funds to lean on the ETFs to improve tax efficiency. For example, the Vanguard 500 Index Fund hasn’t paid a single capital gain since 2001 when the patent was created, as its managers can use the ETF’s authorized participants to receive the stock. 1
This provided Vanguard with a huge edge in gathering assets, reducing costs for investors, and helping it dominate ETF league tables.
New Competition
All good things must come to an end. For Vanguard, the end of its patent came over the spring. In May of this year, that patent expired. And it looks like several heavyweights have started to look for relief under the expiration and start their own ETF share classes of their mutual funds.
The kicker is that these filings have been for active mutual funds.
First was Australia’s Perpetual. Then this summer, heavyweight Dimensional Fund Advisors (DFA) filed with the SEC to begin using the expired patent on its mutual funds. 2 DFA already made a splash in the world of active ETFs through its use of mutual fund-to-ETF conversions. Those moves have quickly made it one of the largest players in the industry. For DFA, the addition of an ETF share class would help limit potential ‘stampeding’ of assets from its funds. Originally only sold through a series of exclusive financial advisors, many of its funds feature very long-term shareholders now entering their golden years.
More recently, investment giant Fidelity—which oversees more than $4.3 trillion in assets—filed to offer ETF share classes of its active mutual funds. In its filing dated October 24, 2023, Fidelity says it’s doing this to “help meet the evolving needs of investors’’ and “for those investors who prefer investing in ETFs and are interested in existing Funds, an ETF Class could be an attractive investment opportunity.” 3 If it gets an exemption, Fidelity could instantly be one of the largest ETF managers on the planet.
Now analysts speculate that other big managers will have to jump in and take advantage. BlackRock, J.P. Morgan, and managers with mutual fund-heavy businesses like Franklin Templeton could be next in line to file their own ETF share classes.
Not There Yet
Before investors get too excited, there are some caveats and potential hiccups in the works. For one thing, the SEC hasn’t budged at all with regard to these filings. Vanguard’s patent was for use with index ETFs. Generally, these market tracking funds don’t necessarily generate that many capital gains in the first place. Active funds could be a different story.
That brings us to the second piece: ETFs’ tax efficiency and their ability to pass-through securities to pay no capital gains tax is already in Washington’s cross-hairs. Back in 2021, Senate Finance Committee Chairman Ron Wyden penned legislation that would create a tax on ETFs to cover the ‘phantom’ capital gains and the creation/redemptions of authorized participants. The legislation has gone nowhere in recent years. But, if active funds and more investment managers start using the patent, we could see the U.S. Treasury start missing enough revenue to tip Washington’s hand.
Second, many mutual fund managers close active funds if they get too big and are unable to meet their mandates. The SEC has no such rules on ETFs. This could be an issue if a fund has an ETF share class.
Finally, a mutual fund share class can potentially hurt the tax efficiency of an ETF if its capital gains are too big to be swapped out via in-kind redemptions. ETF capital gains are very rare, but they do happen. And they could happen more with active funds and the firms using the patent.
Early Days
With Vanguard’s patent just now expiring, we are in the early days of firms starting to use the structure. Odds are in favor of those firms that offer index funds jumping on the bandwagon first. Firms like Fidelity, BlackRock, and T. Rowe Price could quickly and easily adopt the structure for these funds.
As for being active, the outlook is a bit murky. The SEC has a full docket on its plate, particularly with all the bitcoin ETF drama. It may be a long while before we get to see ETF share classes of active mutual funds. And even then, Washington may have its say on taxes. That could dent the entire process.
Either way, active ETFs are quickly becoming the go-to fund structure for many asset managers and investors. With mutual-fund-ETF conversions, new launches or copy-cat ETFs of existing mutual fund strategies, the active ETF boom is on. Vanguard’s patent expiration could be the next leg up for firms looking to launch products and gain assets.
The Bottom Line
Vanguard’s patent allowed use of ETFs as a share class for its mutual funds. And now, with that patent expiring, many firms, from Fidelity to DFA, are trying to use it for active strategies. This could be a game changer for the industry, although there are some hurdles to clear first.
1 Vanguard (November 2023). VFIAX 500 Index Fund Admiral Shares
2 DFA’s SEC filing (July 2023). DFA’s Form 40-APP Filed with the SEC
3 Fidelity’s SEC filing (October 2023). Fidelity’s Form 40-APP Filed with the SEC
