The patent that’s given Vanguard Group an edge over competitors for the past 20 years — and helped its clients pull in more than $100 billion worth of additional investment gains — expired today.
Rival fund managers are now free to replicate a unique but controversial fund structure created by the Jack Bogle-founded firm in 2001 that allows mutual funds to act like exchange-traded funds by generating returns for investors while minimizing taxes.
It’s unclear if the expiration marks a minor footnote in history or a pivotal moment for fund managers looking for a fresh edge in an increasingly cutthroat market. The answer in large part is riding on the US Securities and Exchange Commission and the stance it takes. Just because it allowed Vanguard to start using the tactic two decades ago doesn’t mean it will allow others to do the same now.
“The SEC is the clear lynchpin here,” said Nate Geraci, president of The ETF Store, an advisory firm. “If they green-light this structure, I expect a number of traditional mutual fund companies to seriously explore using it.”
The regulator needs to grant companies exemptive relief from current rules that would let them use the fund structure that effectively gives a mutual fund access to the famous tax efficiency of ETFs.
“The SEC has no obligation to grant the requested relief,” said Jeremy Senderowicz, a shareholder at law firm Vedder Price. “Because there are no formal requirements for the SEC to even respond in a given time to applications for exemption relief, there is no guarantee that there will be feedback from the SEC in any specific timeframe.”
So far, only one other company, PGIA, the US arm of Australian asset manager Perpetual Ltd., has asked the SEC to add ETFs to the share classes of its actively-managed mutual funds. That’s slightly different from Vanguard, which has only ever used the structure in index-following funds.
“It’s been constructive,” said Robert Kenyon, the chief operating officer of PGIA, adding that the SEC has asked for additional days to review the filing. He expects to hear a response from the regulator in August.
The SEC declined to comment.
To be sure, prior to today, the ETF-within-a-mutual-fund structure was available to issuers that agreed to a licensing arrangement with Vanguard, alongside gaining exemptive relief from the SEC. But no other fund managers have been successful. VanEck filed for exemptive relief to offer index ETF share classes through 2012 and 2015, but it was never granted.
Given the explosive growth of the ETF industry, it’s unclear how much demand there would ultimately be for the new structure. In 2022, the gap between money flowing out of mutual funds and inflows into ETFs grew to a record $1.5 trillion, according to data compiled by Bloomberg.
Most major fund issuers now offer ETFs, which are popular with investors because they’re easy to access and tend to be cheaper to trade. And in a recent trend, billions of dollars of mutual fund assets have been converted into ETFs.
Still, Douglas Yones, head of exchange-traded products at the New York Stock Exchange, said that several other asset managers are planning to file with the SEC for permission to create exchange-traded funds as a share class of mutual funds.
“In some cases we’re doing exploratory conversations with asset managers to just talk through what a multi-share class ETF would look like,” said Yones, who helps managers with complex or novel filings that require SEC approval.
In recent years, US regulators introduced sweeping rule changes to make launching ETFs easier, and the SEC deliberately retained the need for issuers to apply for an exemption if they wanted to pursue ETFs in a multiple share class structure.
“If the SEC doesn’t allow this structure for additional asset management firms, there will be real questions raised as to whether the SEC is perpetuating an unlevel playing field by only allowing the already dominant Vanguard sole use of this expired patent,” said Geraci.
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