In late April, asset manager PGIM filed a request with the SEC for exemptive relief to offer its existing mutual fund shares in the form of ETFs. PGIM joins several other asset managers, including Fidelity Investments, Morgan Stanley Investment Management and Dimensional Fund Advisors, in asking for permission to offer this dual-share asset class.
According to its website, PGIM operates over 70 mutual funds, ranging from PGIM Total Return Bond Fund to PGIM Jennison International Opportunities Fund.
The approval of a dual-share asset class would be a “potential game-changer for both mutual funds and ETFs,” said Matt Collins, head of ETFs with PGIM Investments.
“The ETF is open architecture to every client type. And the mutual fund can be a little more directed on the distribution side. To the extent that we can bring the scale that we have and offer access to a new client type that’s the entire point outside of efficiencies of scale and tax benefits that come along with it,” he noted.
Collins added that potential investors would benefit from participating in one of PGIM’s existing multi-billion-dollar funds rather than a newly launched ETF with a much smaller net asset value.
In March, mutual funds experienced $11.2 billion in outflows, while ETF inflows reached $102.5 billion, according to a report from consulting firm Cerulli & Associates.
Making mutual funds available as ETFs is attractive for PGIM and other asset managers because it would create efficiencies of scale by allowing the operation of two different types of funds out of the same portfolio, according to Aniket Ullal, vice president of ETF data and analytics, with research firm CFRA.
A dual-share structure would also open the way for ETF issuers to access the almost $7 trillion 401(k) market that remains largely closed to them, said Aisha Hunt, principal with law firm Kelley Hunt. Kelley Hunt currently represents F/m Investments, a subsidiary of Diffractive Management Group, in its application for exemptive relief to offer its ETFs in a mutual fund share class.
A dual-share structure would likely be a hit with RIAs as well, according to Bryan Armour, director of passive strategies research, North America, with Morningstar. “It sort of allows mutual funds to meet investors where they are. If someone prefers ETFs, they could choose an ETF. And it would be a way for you to offer an ETF from an existing strategy while keeping your mutual fund in retirement plans,” he said.
Some asset managers are already doing that by launching ETFs that clone their mutual fund strategy, “but then it creates all sorts of problems with distribution,” Armour said. For example, wirehouses with access to platforms that sell both the mutual fund and the ETF version can pull their money from the mutual fund into the ETF because it’s cheaper.
Ullal points to mutual fund to ETF conversions as a proxy for the level of investor demand there might be for a dual-share asset class. “A company like Dimensional has had a lot of success with converting mutual funds to ETFs and the demand was pretty strong,” he said.
For example, Dimensional Fund Advisors converted a mutual fund into Dimensional U.S. Core Equity 2 ETF (DFAC) in June 2021. The ETF currently holds $26.7 billion in net assets, up from $21 billion at the time of conversion. The fund has seen $9.5 billion in inflows since listing. In 2023, it delivered a return of 21.86%.
Altogether, there have been 78 mutual funds that converted to ETFs so far, with three funds closing post-conversion, according to Morningstar data. Net inflows for these funds since conversion to ETFs totaled $21.6 billion as of March 31. However, when ETFs managed by Dimensional Fund Advisors were taken out of the total, the remaining funds saw roughly $1.5 billion in net outflows post-conversion.
“Dimensional has been significantly more successful than everyone else,” Armour said. For example, JP Morgan Realty Income ETF (JPRE) experienced $666 million in outflows since conversion, while EA Bridgeway Omni Small Cap Value ETF (BSVO) saw outflows of $560 million.
In Ullal’s view, the mutual funds that will likely see the most attention from RIAs if offered as a dual-share asset class are those already seeing strong demand from that channel. “I think this will probably be of more interest in the active equity space and active fixed income. Those would be the growth areas because the index area is already very mature,” he said.
Collins confirmed PGIM was looking at dual-share offerings for mutual funds with “known strategies” to avoid creating competition between its various funds. In addition, “for those kinds of strategies where there are serious capacity constraints, we might think twice about having an ETF just because an ETF is harder to manage,” he said.
How Likely Is Approval?
The SEC has no deadline to respond to asset managers’ requests for exemptive relief. However, in early April, Cboe Global Markets asked the SEC to approve the addition of dual share ETFs to existing mutual funds. According to Armour, the SEC would have until year-end to respond to that request.
For the most part, market observers are optimistic the SEC will eventually approve dual-share structures.
“I think it’s very likely that the SEC will grant relief,” said Hunt. “Right now, Vanguard is operating dual-share class models that have benefited from exemptive relief; they have a monopoly on that structure. The SEC has to take into account that the Vanguard model is in existence.”
Vanguard secured a patent in the early 2000s, allowing it to offer a dual-share class structure for its mutual funds for the past 20-plus years. That patent expired in May of last year, and it was granted only for passive funds, according to Armour. He noted that Vanguard’s request to use dual shares for its actively managed funds was denied.
The SEC has several concerns about using dual shares for mutual funds/ETFs. The first is that mutual funds are required to keep a certain amount of cash reserves handy to satisfy redemptions, while ETFs can use securities instead of cash to trade “in kind.” Hunt noted that, as a result, SEC officials worry about mutual funds’ reserve requirements creating a cash drag on the ETF and putting the ETF investors at a disadvantage.
Another potential issue is how the funds’ expenses would be paid. Hunt noted that mutual funds typically pay for expenses, other than the management fee, out of fund assets. With ETFs, on the other hand, the manager usually pays for the fund expenses. This discrepancy can also lead to investors in one share class paying for the expenses of the other. “One of the things we are doing in our application is proposing the unitary fee be charged for both classes,” Hunt said.
Collins agreed that a number of details concerning transaction costs and tax efficiency surrounding a dual-share asset class still need to be figured out to satisfy the SEC’s concerns.
However, Hunt believes hybrid funds will be the way of the future, and RIAs need to start familiarizing themselves with how such vehicles will work.
“Managers are going to be incentivized to have dual-share class models,” she noted. “Ultimately, the investment universe will convert to consisting of hybrid funds, so it’s really important that RIAs understand the implications of dual share classes for their clients.”