Dual Share Classes Are Here, But There’s an ‘Apollo 13’ Problem

The approval of dual share classes may be one of the fund world’s biggest changes in decades, but it’s facing an age-old problem: square peg meets round hole.

The settlement processes that underpin the fund structures weren’t designed to work together and were established years apart, which complicates things for intermediaries handling trades of mutual fund shares for ETFs. “The best analogy is that scene in Apollo 13 where they’re trying to get the carbon dioxide out of the spacecraft,” said Kip Meadows, CEO of fund service firm Nottingham, pointing to modules made by different manufacturers. 

Like ETF and mutual fund settlement processes, “the two systems don’t fit together because they were built at different times,” he said. Fortunately, NASA engineers helped the three astronauts improvise a connector for the cylindrical carbon dioxide scrubbers from the lunar module and the cubic ones on the command module. And, let’s be real: The consequences in that situation were much more important than dual share classes.

Just Around the Corner

The biggest difference is mutual funds being held in fractional shares versus ETFs’ whole ones. Now that the federal government shutdown has ended and the Securities and Exchange Commission is back to work, dual share classes were approved for Dimensional Fund Advisors this week, and other companies that mostly replicated DFA’s application per the regulator’s requests, will likely soon follow. That means some mutual funds will have ETF share classes added to them, and vice versa, and investors will exchange shares of one for the other. “You’re always going to have an amount left over,” Meadows said of mutual fund assets being moved to ETF shares. “You have to know what the shareholder wants to do with that fractional share.”

Ahead of dual share classes, intermediaries have some things to consider, attorneys at law firm Morgan Lewis recently wrote:

• Dual share classes may affect investor suitability and advisors’ fiduciary responsibilities or obligations under Regulation Best Interest. Improving disclosure and point-of-sale practices will help limit liability in instances of customer complaints or from regulatory examinations.
• They should also think about how this will affect compensation, such as from revenue sharing or 12b-1 payments, and how to add dual share class funds onto their product lineups.

Save It for Later: More than 80 firms have filed with the SEC for dual share classes, though few will add them immediately after getting approval. Operationally, many won’t be ready, and there will likely be distribution hurdles with broker-dealers that aren’t eager to add ETFs. Regarding how well-prepared firms are, “that would probably be 87 different answers,” Meadows said. “This [government] delay may have been a good thing, to be able to think through the business side.”