A Regulatory Change in the United States Could Enable Asset Managers to Integrate ETFs and Mutual Funds in Their Portfolios, in an Industry Witnessing the Unchecked Growth of Exchange-Traded Funds
A regulatory change in the United States could enable asset managers to integrate ETFs and mutual funds in their portfolios, in an industry that is witnessing the growth—with no limits in sight—of exchange-traded funds. Experts consulted by Funds Society confirmed that the regulator seeks to modernize and simplify the structure of investment funds in the United States and indicated that it would be a positive move for retail investors. However, they also warned that it could benefit large-scale managers to the detriment of smaller firms.
At the end of last September, the SEC issued a statement titled “Back to Basics: Statement on Exemptive Relief for ETF Share Classes,” making public its intention to approve a request submitted by DFA (Dimensional Fund Advisors) to allow open-end funds (mutual funds) to simultaneously offer exchange-traded shares (ETFs).
“The Commission is taking a long-awaited step toward modernizing our regulatory framework for investment companies, reflecting the evolution of collective investment vehicles from being primarily daily redeemable funds to exchange-traded funds (ETFs),” stated Commissioner Mark T. Uyeda in that statement.
The proposed regulatory change targets the domestic U.S. market, and although the regulation has not yet been ratified, it holds transformative potential for the entire industry.
“As mutual funds and ETFs become more democratized, assets tend to shift toward ETFs, since traditionally fees are lower and taxes, without a doubt, are also much lower,” explained to Funds Society Gil Baumgartenh, CEO of Segment Wealth Management, an RIA based in Houston, Texas.
“Reducing the barriers to converting open-end funds into closed-end ETFs through a share-class matching scheme—like the one proposed by Dimensional Funds—is positive for investors and will accelerate the trend of converting other mutual funds into ETFs if the SEC approves it,” he added.
It is expected that many other asset managers who have already submitted similar requests (more than 80, according to global law firm Ropes & Gray) will file similar amendments to align with the DFA model.
“The measure seeks to modernize and simplify the structure of investment funds in the United States, which until now have had to keep their traditional mutual funds and their ETFs separate, even though they often invest in the same assets and follow the same strategy,” said Jorge Alejandro Antonioli, Investment Development Manager at Supra Wealth Management.
“At the asset manager level,” he continued, “this creates duplicate costs, different legal structures, and lower operational and tax efficiency. With this measure, the SEC would allow, under an exemption regime at first, a fund to have two classes: one exchange-traded class (ETF) that investors can buy and sell during market hours and another non-traded class that operates with an end-of-day NAV as mutual funds traditionally do.”
Main Advantages
The regulatory change has benefits associated with greater liquidity, lower management costs, and access without investment minimums, noted the expert from Supra WM. “It is always good for retail investors to have more investment options; being able to access the same asset through two different financial instruments simply gives the retail investor more options, and that is always good,” said María Camacho, a market analyst with a recognized track record in the industry.
In her opinion, the issuance of active ETFs is becoming more common, and in this way one could access either a mutual fund or an ETF to obtain active portfolio management. “I firmly believe in the added value of active management and consider that if an advisor knows how to select good active managers, their client will achieve above-average results,” she added.
Baumgartenh also believes the change should benefit retail investors. “It may not necessarily result in lower fees, although it’s possible,” he stated. ETFs offer better liquidity and a more favorable tax treatment than traditional open-end funds, and the tax-free exchange that would be offered through share class conversion would be highly beneficial for long-term shareholders, from his point of view.
From Supra Wealth Management, Antonioli noted that the SEC proposal could put downward pressure on the revenue earned by traditional firms and could pave the way for firms to adopt new billing models, such as fee-based schemes or the adoption of a fiduciary system.
The CEO of Segment Wealth Management assessed that if the regulation is approved, it will likely accelerate the disappearance of 12b-1 fees, more than directly affecting commissions. “Many mutual funds already offer no-load share classes,” he said. “Brokerages and fund companies are reluctant to give up 12b-1 fees, which are essentially a form of retrocession.”
Baumgartenh explained that some ETFs “include nominal 12b-1 fees, but nothing comparable to what is typical in traditional open-end funds. This share class conversion will accelerate the end of the traditional open-end mutual fund model and will force most companies to adopt changes similar to those proposed by Dimensional Funds. This will hurt brokerages and the portion of the business that depends on commissions, as well as the IRS (U.S. tax authority), due to reduced tax collection.”
Camacho, for her part, admitted that downward pressure on fees “is a constant reality,” although she stressed that what matters is net return: “If there’s a manager who charges more than another but delivers better net-of-fees results, I will always prefer the more expensive one, because they deliver better outcomes.”
Some Industry-Level Risks
The reality is that the rule change could strengthen large firms with investments in infrastructure, technology, scale, and distribution, and conversely, could become a challenge for smaller firms, warned the expert from Supra.
“The implementation of the new measure by the SEC,” he added, “will constitute a regulatory and economic paradigm shift that will benefit managers with scale, technology, and operational muscle to sustain daily regulatory, compliance, and evaluation processes. At this point, I believe the regulation should take care to avoid creating ‘too big to fail’ giants and ensure appropriate conditions so that small or mid-sized managers with strong track records are not absorbed or driven out of the market.”
In the same vein, Camacho noted that “with technological and regulatory progress, we are increasingly seeing more concentration among asset managers, where good managers will always be able to attract more assets than poor managers, resulting in capital concentration among the best managers.”
“The shift toward the ETF structure has been underway for several decades,” stated Gil Baumgartenh from Segment Wealth Management. The expert does not believe the rule will result in the disappearance of mutual fund companies, “but it will force them to convert their structures to ETFs and should promote consolidation. The smaller, less competitive firms already under pressure from investors’ preference for lower-cost index products will be the most affected. Many of them have probably been debating whether to offer ETFs for some time without taking action; this regulation will finally compel them to do so,” he concluded.
