SEC’s Potential Shift for Asset Managers

Marc Weda, a Commissioner at the Securities and Exchange Commission (SEC), is scheduled to speak at the 2024 Financial Market Quality Conference at Georgetown University on September 17, 2024.

The SEC is considering allowing numerous asset managers to merge traits of exchange-traded funds (ETFs) and mutual funds, a decision that could shift tax implications and broaden investment choices.

Over 50 asset managers have requested exemptions from the SEC to offer ETF share classes for their existing mutual funds. Vanguard currently does this and has been operating within established SEC frameworks, but other firms must keep a sharp division between these fund types.

This long-term industry goal has gained momentum lately. SEC committee member Mark Ueda mentioned in March that he was tasked with prioritizing this topic. By March 31, Dimensional Fund Advisors updated their application based on feedback from SEC staff, prompting at least 45 of the first 53 applicants to revise their submissions, as reported by Morningstar.

“What seems to be happening now is that we’ve essentially created a template for the industry to follow,” Dimensional Co-CEO Gerard O’Reilly remarked.

Implications for Investors

Today, many ETFs and mutual funds offer similar investment strategies, often featuring nearly identical options in both categories from the same provider. Nonetheless, key distinctions exist. Generally, ETFs provide more transparency regarding their holdings and can be traded on stock exchanges.

However, tax treatment might be a standout difference for investors. Due to their structure, when a shareholder withdraws funds from an ETF, the resulting share sales typically do not generate capital gains taxes for other shareholders, unlike mutual funds. The SEC is hesitant to approve these relief requests partly due to concerns over unexpected tax liabilities for ETF holders.

“We’re glad to announce that Benjamin Schiffrin, Securities Policy Director at Better Markets, stated the group is open to potential changes,” suggesting a flexible approach to the current regulations.

Dimensional’s revisions include updated guidelines to help monitor how these funds manage tax consequences, according to O’Reilly. The SEC has not commented on this matter.

This regulatory relief could allow asset managers to efficiently bring successful mutual fund strategies to the ETF sphere without the need to establish new funds. This would provide investors with more options, especially since many have drifted away from mutual funds over time.

Matt Barry, head of capital markets at Touchstone Investments, noted that clients are increasingly inclined toward ETFs. The upcoming changes could facilitate the rapid expansion of his firm’s ETF offerings.

“We hope this truly provides the best of both worlds,” Barry added, suggesting it would cater to both mutual fund loyalists and those who prefer the flexibility of ETFs.

This adjustment could simplify sales for ETFs. Current guidelines prevent firms from referring to the successful long-term performance of mutual funds when developing new ETF versions, even if the strategy and management teams remain the same.

If the SEC successfully enables ETFs to align better with mutual fund class structures, similar approaches could potentially work in reverse.

Looking Ahead

Securing legal approval from the SEC will be a step-by-step process, elaborated Brian Murphy, a partner at Stradley Ronon. SEC staff will draft memos for committee review, followed by commissioner approval for a publication notice period. Relief might be granted about 25 days later.

However, the actual implementation of new share classes might take longer. O’Reilly mentioned that approval from boards governing individual funds could extend the process, possibly taking 6 to 9 months before additional share classes become available.

This delay largely aims to ensure harmony among all stakeholders, including the company, fund service providers, brokerage platforms, and exchanges. Giang Bui, head of U.S. equities at Nasdaq, mentioned adjustments to the incentive programs for market makers might be necessary to create a sustainable environment for new ETFs.

Nevertheless, if all goes well, SEC regulatory changes could significantly dismantle the existing barriers between mutual funds and ETFs. O’Reilly concluded, “There’s no reason they can’t be seen as a single asset class in the next decade.”