Vanguard Requests Active ETF Share Classes

Today, The Vanguard Group added its name to the growing list of asset managers seeking SEC approval for an exchange-traded fund share class of its actively managed mutual funds. It joins more than 60 other asset managers, including BlackRock, State Street, and Fidelity, that have applied for the hybrid share class structure over the past two years.

Vanguard pioneered the ETF-as-a-share class structure 24 years ago. Vanguard Total Stock Market ETF VTI

, a share class of Vanguard Total Stock Market Index VTSAX

, entered the world on May 24, 2001. Over the subsequent years, Vanguard appended an ETF share class to nearly all its index-tracking mutual funds.

Tax efficiency was Vanguard’s imperative at the time. ETFs use daily in-kind transactions to track the value of their underlying portfolios. Those transactions are tax-free. Well-managed ETFs can use them to purge unrealized capital gains and reduce, if not eliminate, capital gains distributions. Adding an ETF share class to a mutual fund allows the money invested via mutual fund share classes to benefit from the ETF’s tax-efficient transactions.

Vanguard prevented others from using the ETF share class by patenting it, but the patent expired in May 2023. Since then, more than 60 asset managers have requested approval from the SEC to combine mutual fund shares with ETF shares.

Vanguard’s current approval is limited to its index-tracking funds. It sought permission to extend the structure to its actively managed mutual funds about 10 years ago, but the SEC denied that request.

For that reason, Vanguard’s latest application differs from others. It is only asking to apply the ETF share class to its actively managed mutual funds. It is not seeking any changes to the conditions that permit an ETF share class on its existing index funds.

Vanguard and its competitors are keen to adopt the ETF share class to reduce potential capital gains distributions and move toward a vehicle that has become more popular. Outflows have plagued actively managed mutual funds in recent years, and they show no signs of slowing. Those outflows can force managers to prematurely sell stocks and bonds with appreciated prices and realize capital gains, which they must distribute to investors at the end of the year. Investors bear the tax consequences of those capital gains distributions, so anything that improves aftertax returns makes a mutual fund more attractive.

An ETF share class is by no means a perfect solution. In rare circumstances, mutual fund share classes can realize large capital gains that the ETF cannot effectively purge. When that happens, the mutual fund shares and ETF shares each distribute a proportion of the capital gains. Those circumstances have only occurred once in Vanguard’s 24 years with the structure.

Furthermore, the structure won’t work for all mutual funds. Some active managers restrict the amount of money they manage to maintain their edge. Mutual funds allow them to close their doors to new money as they approach those limits, but ETFs trade on an exchange and cannot be closed to new money. Adding an ETF share class would forfeit that flexibility.

That said, the benefits can outweigh the drawbacks. When applied to the appropriate mutual funds and managed prudently, ETF share classes are a positive development for investors.