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Vanguard is the second-largest exchange traded funds issuer and its margin over the third-place firm is massive. In fact, the index fund pioneer is close to grabbing the top spot from BlackRock’s iShares.
In addition to enviable brand recognition, low fees and strong ties to the advisory/wealth management community, one of the reasons Vanguard rapidly became an ETF Goliath is because it introduced ETF share classes of already popular index and mutual funds. Until May 2023, that hybrid structure was patent-protected.
As is the case in the world of pharmaceuticals, Vanguard’s patent expired, setting the stage for competitors to use the previously protected structure. They’re doing just that. In the roughly 18 months since the Vanguard patent expired, mutual fund issuers – some of which are already ETF giants in their own rights – have filed a slew of applications to add ETF share classes for some of their actively managed funds. That group includes BlackRock, Dimensional Fund Advisors (DFA), Perpetual/PGIA and State Street Global Advisors (SSAG), among others.
Proving that Vanguard ETF share class structure is appealing to issuers, 30 sponsors filed related applications in the first 10 months of this year.
Expect More
It’s been widely documented that the mutual fund-to-ETF conversion cycle is in its early innings and is gaining significant momentum as sponsors of active mutual funds look to stem the tide of outflows.
“Mutual funds are struggling to attract investors. Many have not performed well, and investors have responded by moving their money,” notes Morningstar analyst Daniel Sotiroff. “More than $510 billion left mutual funds in 2023. Another $300 billion exited over the first 10 months of 2024, while ETFs collected more than $800 billion of new money.”
To that extent, the expiration of the Vanguard patent is meaningful because it paves the way for more issuers to create ETF classes of established mutual funds and the reality is many advisors and retail investors are more likely to allocate capital to an ETF than they are to a mutual fund. One of the reasons for that phenomenon is the tax efficiency of ETFs, even actively managed products, over mutual funds.
“The motivation for doing so is simple to understand. Taxable capital gains distributions have plagued many mutual funds over the past several years,” adds Sotiroff. “Adding an exchange-traded share class extends its tax efficiency to mutual fund share classes and potentially solves part of the problem. But it isn’t an instant remedy, and it comes with additional considerations.”
Vanguard ETF Share Class Not for Everyone
Still, not all active fund issuers are rushing to file applications to use the Vanguard structure – a reminder that it’s not a cure for all fund sponsors and it’s not a perfect methodology. Nor is it one that should be deployed with all actively managed mutual funds.
“Other major mutual fund providers have yet to submit a request, including Capital Group/American Funds, Pimco, and Invesco. Why they haven’t filed isn’t clear, but the hybrid structure does have some drawbacks,” concludes Sotiroff. “ETFs can’t shut their doors to new money to control capacity and maintain their edge, a practice that some actively managed mutual funds have deployed under the right circumstances. Bolting an ETF onto a mutual fund effectively eliminates that capability.”
Invesco is already one of the largest ETF issuers, the bulk of which are passive products. For its part, Pimco has found success with active fixed income ETFs, some of which are essentially ETF versions of well-known mutual funds, and that success was accrued without using the Vanguard template. Point is more mutual fund-to-ETF conversions are coming and the Vanguard patent expiry helps, but it’s a playbook that could or should be deployed in blanket fashion.