ETF Intel Q&A: Ropes and Gray

Danielle Rutsky, Lead Product Manager of ETF Listings at Nasdaq, joins Edward Baer, Counsel at Ropes & Gray, for a conversation about the growing interest in ETF share class structures and how fund sponsors are preparing for potential SEC relief with guidance from Ropes & Gray.

1. How is Ropes & Gray involved in the ETF share class applications?

Ropes & Gray has worked with more than a dozen clients to submit ETF Share Class Applications, including applications for ETF share classes of mutual funds, mutual fund share classes of ETFs, both ETF and mutual fund share classes, and share classes for semi-transparent active ETFs. We also published the white paper and held a webinar attended by hundreds of clients. Ropes attorneys have also worked closely with the Investment Company Institute, SIFMA and the Independent Directors Council on a number of meetings and webinars related to ETF share class relief, including various operational challenges posed by the relief. We expect to issue in the near future additional white papers exploring the specific requirements of the ETF share class relief and some of the operational issues that will need to be addressed before fund sponsors offer ETF share classes.

2. Why are fund managers asking the SEC for relief to allow an ETF share class and a mutual fund share class under the same fund?

For over 20 years, Vanguard has had SEC relief to offer an ETF share class of certain of its index-based mutual funds. Vanguard also held a patent on the ETF share class structure that expired in 2023. Because the patent was expiring, a number of firms have asked the SEC to grant similar exemptive relief to operate ETF share classes of index-based and active mutual funds. The ability to launch an ETF share class with an established track record at scale holds significant appeal for fund sponsors. Having mutual fund and ETF share classes of the same fund also offers operational and trading efficiencies, as well as distribution flexibility.

3. How long could it take for a traditional mutual fund shop to launch an ETF a share class of a mutual fund if the SEC approves these applications?

Given that there are now more than 60 firms seeking ETF share class relief, it’s obvious that there is significant interest in the structure. However, it is unclear whether and when the SEC will grant ETF share class relief, and precisely what the parameters of that relief will be. A lot of work remains to be done before we will see ETF share classes of mutual funds. Each sponsor will have to prepare an initial report for their fund board to enable them to determine whether ETF share classes will be in the best interest of the whole fund and each class. Fund sponsors will also have to design an ongoing monitoring and reporting program to enable the fund board to evaluate whether the ETF share classes are operating consistent with expectations. This will include establishing and monitoring numerical thresholds to analyze items that may result in “cross-subsidization” of one class by another class like brokerage expenses, cash drag and tax impacts. In addition, fund sponsors will have to file registration statements for each new fund share class. There are also a number of operational details that remain to be worked out, including how mutual fund into ETF share class exchanges will work and how different mutual fund and ETF service providers will interact with each other. Finally, it remains to be seen whether and how distribution platforms will support ETF share classes. Given these obstacles, it would be a significant achievement if new ETF share classes are available in 2025.

4. How are mutual funds and ETFs different in terms of their organizational structure and fee structure?

Mutual funds and most ETFs are governed by the 1940 Act and are structurally similar*. Both are overseen by boards and managed by an investment adviser. Mutual funds tend to have different expenses than most ETFs, and their presentation of fees differs from that of an ETF. For example, most ETFs have a unitary fee out of which they pay fund expenses such as custody, fund administration, transfer agency, legal and audit fees, with the investment adviser retaining the difference between the unitary fee rate and what it pays out for these services. In contrast, mutual funds typically have a management fee and a separate line item for “other expenses” that covers custody, fund administration, transfer agency, legal and audit fees, as well as certain shareholder service and other expenses. Mutual funds also typically pay a separate Rule 12b-1 fee that ETFs do not typically bear. It is unclear whether ETFs that will be offered as a share class of a mutual fund will charge a unitary fee or instead adopt the typical mutual fund approach. This will be just one of the important considerations advisers and fund boards will have to address when establishing ETF share classes.

*There are a handful of ETFs that are organized as unit investment trusts (including SPY and QQQ) that differ from most ETFs in that there is no board or investment adviser.

5. What questions should a fund manager have answered before launching an ETF as a share class of a mutual fund?

The ETF share class exemptive applications contain a number of specific items fund sponsors and boards will have to evaluate before determining to offer ETF share classes. These include items like the reasonably expected benefits and costs to each class individually and the fund as a whole, including the sources of potential cost savings and other benefits of operating a multi-class structure. In addition, with respect to the risk of cross-subsidization, the board should consider the impact of (i) reasonably expected cash flows and costs associated with portfolio transactions, (ii) reasonably expected cash levels, and (iii) reasonably expected distributable capital gains. In addition, board will need to consider the impact of daily disclosure of portfolio holdings and any anticipated capacity or other constraints on specific asset classes. As noted above, before offering ETF share classes, the fund board must find that the structure is in the best interests of each mutual fund class and ETF class individually and of the fund as a whole. Once the board determines to offer an ETF share class, the exemptive relief will require significant levels of ongoing monitoring and reporting.