Transcript

Scott: 

Hello, I’m Scott Snyder and I am very pleased to be joined today by Guy Stanzione from Toppan Merrill’s SEC Compliance Services Team. Guy, thank you very much for being here and welcome back to On The Dot. 

Guy:                                                                                                                       

Thanks, Scott. It’s a pleasure. 

Scott: 

Guy, today’s topic is ETFs. They have been a growing segment of the investment company space for several years now, but recent share class conversations have spiked interest.  

The ETF share class represents a significant modernization in the asset management industry. Investors are drawn to ETFs for their relatively low cost, intraday tradability, transparency, tax efficiency, and exposure to specific markets or strategies. But let’s start with the regulatory side of the equation for our conversation today and the SEC specifically. Can you give us an update on their position on the ETF share class? 

Guy: 

The first thing to be aware of is the SEC has publicly stated that it is in favor of ETF share classes, but doesn’t plan to introduce new rulemaking related to the topic, instead relying on Exemptive Applications. The expected relief for funds with both ETF and Mutual Fund share classes provides an opportunity to broaden investor choice, promote efficiency and economies of scale, and enhance competition in the asset management sector.  

The SEC feels that share class ETFs should utilize the Exemptive Application process, so it can review the circumstances of each applicant and assess the request against relevant policy considerations. 

Scott: 

So, let’s talk about Exemptive Applications for a moment. Can you provide an example of what you’ve seen so far with the SEC? 

Guy: 

Sure, there have been a number of applications for relief filed with the commission. A good example is Dimensional Fund Advisors, which we’re going to discuss today. Dimensional stated in their application, their belief that the ability of a fund to offer both Mutual Fund shares and ETF shares could be beneficial to the fund and to shareholders for each type of class. They believe the multi-class structure will allow investors to choose the manner in which they hold interest based on the share class characteristics that are most important to them. 

Scott: 

So that’s a pretty important distinction. Yet, aren’t there significant differences, Guy, between how an ETF and a Mutual Fund operate? 

Guy: 

Yes, there are. Although they believe there was limited potential for confusion between the classes, in the Dimensional Fund Advisors Application, they’ve stated they will take numerous steps to ensure that investors clearly understand the structure of a Multi-Class ETF Fund and the differences between Mutual Fund shares and ETF shares. Here are five disclosure steps they outlined: 

1. All references to the ETF shares will use a generic term such as ETF in connection with those shares or a form of trade name rather than the Fund name.
2. There will be a separate prospectus for a Fund’s ETF shares and Mutual Fund shares.
3. Each Mutual Fund class will prominently disclose in its prospectus and on its website that the fund offers ETF class and vice versa.
4. The cover and summary section of a fund’s ETF shares prospectus will include disclosure that the ETF shares are listed on an Exchange and are not individually redeemable.
5. Finally, to the extent Mutual Fund shares may be converted into ETF shares as part of an Exchange Privilege, a fund’s Mutual Fund shares prospectus will contain appropriate disclosure about the ETF shares and the Exchange Privilege. 

Scott: 

Guy, that’s a great example of the exemptive relief application with Dimensional Fund Advisors. Before we move on, anything else you want to add about the Exemptive Application process itself for other issuers? 

Guy: 

Although each application is different, the SEC has instructed applicants to follow the Dimensional model as the template for future applications.  

In that vein, Dimensional requested an order that would permit a registered open-end management investment company to offer one class of exchange traded shares that operates as an ETF and one or more classes of shares that are not exchange traded.  

The Order would provide Multi-Class ETF Funds with two broad categories of relief: 

1. The relief necessary to permit standard ETF operations consistent with Rule 6c-11.
2. The relief necessary for a fund to offer an ETF class and one or more Mutual Fund classes. 

Scott: 

Interesting, so would the SEC’s order provide any other benefits to the applicant themselves and then correspondingly other applicants attempting to follow their lead? 

Guy: 

Yes, the order would potentially provide ETF operational and ETF class relief. The ETF operational relief would permit: 

1. ETF shares of a Multi-Class ETF Fund to be listed on a national securities exchange as defined in Rule 6c-11, and traded at market designated prices.

2. ETF shares to be issued to and redeemed by authorized participants in creation units only and as permitted by Rule 6c-11(a)(2).  

The ETF class relief order would permit a Multi-Class ETF fund to offer one ETF class and one or more Mutual Fund classes. This Multi-Class ETF Fund structure would comply with Rule 18f-3, except for certain ways in which an ETF class and Mutual Fund classes would have different rights and obligations. Additionally, the Multi-Class ETF Funds may offer an exchange privilege that would permit shareholders in a Mutual Fund class to exchange Mutual und shares for ETF shares. 

Scott: 

Guy, thanks for all of that information. I know it’ll be really beneficial for our audience. Let’s pivot a little bit with the interest in ETFs. I imagine there’s a lot of attention within the industry as well and industry groups. Can you talk about what you’re hearing from them? 

Guy: 

There is, for example, the ICI has working groups focused on the investor experience, evaluating the potential impact for intermediaries, reporting requirements, operational support for the interclass exchange privilege, and the technology and systems that could affect the development and launch of a dual share class product. 

Scott: 

Great Guy, we’ve now covered the regulatory aspect of ETF so far. You’ve touched on the industry. Let’s move more specifically to benefit highlights for ETFs and funds themselves. Can you touch on that for our audience? 

Guy: 

Absolutely. The Exemptive Application stated three specific benefits: 

1. Transactions through the ETF class in connection with creations and redemptions may contribute to lower portfolio transaction costs and greater tax efficiency and could allow a fund to reduce some portfolio management costs.

2.The ETF class would represent an additional distribution channel for a fund that could lead to additional asset growth and economies of scale.  

3.The exchange privilege could allow Mutual Fund shareholders to exchange Mutual Fund shares for ETF shares without adverse consequences to the fund. 

Scott: 

So how would Mutual Fund classes, then, Guy, offer benefits to those shareholders in a fund’s ETF class? 

Guy: 

There are four ways the shareholder would benefit: 

1.Investor cash flows through a Mutual Fund class can be used for efficient portfolio rebalancing.  

2.Cash flows through a Mutual Fund class may allow for greater basket flexibility, which could promote arbitrage efficiency, and smaller spreads on the trading of ETF shares in the secondary market.

3.Existing funds offering an ETF class would permit investors that prefer the ETF distribution channel to gain access to established fund investment strategies.

4.The establishment of Mutual Fund classes as part of an existing ETF could lead to cost efficiencies and economies of scale as it attracts additional investments into the fund. 

Scott: 

Guy, let’s continue on this theme. Is there a specific impact on fund operations of the ETFs? 

Guy: 

Yes. Each Multi-Class ETF Fund will operate pursuant to a plan required by Rule 18f-3. Before the first issuance of a share of any class and before any material amendment of the multiple class plan, the board of directors of the fund must determine that the multiple class plan is in the best interest of each Mutual Fund and ETF class individually and the fund as a whole. 

Scott: 

Terrific. Guy, let’s take a quick moment to touch on specific differences now between the Mutual Fund and ETF rights of the issuer. 

Guy: 

The Exemptive Application identified several ways the Mutual Fund shares and the ETF shares will have different rights. Four of those include: 

1.Mutual Fund shares will be individually redeemable while ETF shares generally will be redeemable only in creation units.

2.ETF shares will be tradable on an exchange while Mutual Fund shares will not.

3.Any exchange privilege generally will be limited to the Mutual Fund class.  

4.The Mutual Fund classes and ETF class may declare dividends on different dates. 

Scott: 

So, Guy, we’ve spoken now about some of the benefits of ETF share classes, but I know you and I have talked about this, we’re also hearing about the challenges fund firms are facing. Can you elaborate on that aspect of ETFs for us? 

Guy: 

Sure. Although fund firms have shown an interest to launch ETF share classes, and there’s been considerable conversation about it. According to a recent Cerulli survey, distributors and service providers may not be ready and or able to support them at this time. Distributors have cited a lack of clear incentives and guidance from fund managers while service providers point to complex conversion processes.  

Interestingly, 30% of the distributors surveyed pointed to operational complexity as their biggest constraint, while 20% each identify technology integration, unclear advisor demand, and lack of clarity from fund firms.  

Beyond the logistics, service providers are concerned about not being aware of fund launch or conversion plans. Six in 10 survey respondents who work at distributors said asset managers have not communicated their ETF share class strategies. Adding to that, according to a recent Cerulli white paper conversion mechanics are costly and resource intensive. The new structure may carry higher fees than traditional ETFs and mutual funds.  

Additionally, broker dealers may be concerned that they would be violating Regulation Best Interest, otherwise known as Reg BI, if they recommend a Mutual Fund class over the ETF version.  

Lastly, some distributors, whether ETF share classes offer a clear benefit to anyone other than the fund firms, with firms not being able to articulate a clear benefit to shareholders. 

Scott: 

Guy, we’ve covered a lot of ground today as we wrap up our conversation on the emergence of ETF share classes. Your final thoughts as the industry looks ahead? 

Guy: 

What I’d say is although interest appears to be high, caution should be taken due to the reasons we discussed. At this time, there have been more than 85 applications filed with the commission for the relief. With the end of the government shutdown and the SEC returning to work, it seems likely that many of the applications will be approved. With less than 40 of the applications planning to launch at this time, many appear to be taking a wait and see strategy while the information required for board approval is collected and an operating model is developed. We’re also hearing there is a lack of conversion automation, which may take time for the mechanism to be in place, since this is not a one size fits all. With the risk of error with a manual conversion process, there’s no reason to rush until a solution is in place. 

Scott: 

Guy, thanks for joining me for this episode of On The Dot and sharing your insight and expertise on ETFs. 

Guy: 

Thanks, Scott, I appreciate you having me.