Dual Share Classes Are Coming Soon. Now, What?

On your mark … get set … wait.

The SEC’s pending approval of dual share classes may be the biggest story of the year for ETFs, but it may nonetheless be a while before ETF share classes of mutual funds, and vice versa, become available to investors. Following the regulator’s notice on Monday that it is set to greenlight Dimensional Fund Advisors’ request for dual share class exemptions, the company noted that it would launch share classes as soon as it is ready. That firm is certainly well ahead of most others in that regard: It already provides a range of funds in both the mutual fund and exchange-traded fund wrappers, and it has been seeking approval for several years. But even Dimensional says there is a way to go.

“We know many investors are eager for the ability to exchange mutual fund shares for ETF shares without incurring transaction costs or taxes,” co-CEO Gerard O’Reilly said in an announcement, adding that custodians will need to get up to speed to facilitate the new products.

Like Sands Through the Hourglass, So Are the ETFs of Our Lives

F/m Investments plans to initially launch mutual fund shares of its US Treasury 3 Month Bill and Ultrashort TIPS ETFs. CEO Alex Morris said it’s a way for issuers to enter into the 401(k) market. “Expect an initial wave of approvals for mature applications, followed by a gradual rollout,” he said. Following SEC approvals, fund boards must consider whether adding share classes is appropriate for products. ETF share classes of mutual funds with capacity constraints, for example, may not be a good fit. 

“It’s going to be a game-changer for the industry,” said Matt Barry, head of capital markets at Touchstone Investments. “You’re going to see a lot of those [active mutual] funds offer ETF share classes … with strategies that are already at scale.” Touchstone, like most others, will likely be a year away from launching the new share classes, he said. That is in part due to the operational challenges that firms will have to address, especially if they specialize in one wrapper, but not the other. And another issue is “the ETF ecosystem’s ability to handle that number [of new] products,” Barry said, citing a potential lack of lead market makers to put up capital to support ETF share classes.

Some highlights of the dual share class application race:

• About 80 companies have requested exemptions, including big asset managers like BlackRock, State Street and JP Morgan.
• The SEC worked with Dimensional to incorporate feedback from the industry in amendments to that company’s application, encouraging other firms to more or less copy it. Applications were revised a couple times this year to address fund boards’ responsibilities, investor disclosures, differences in dividend schedules between product types and other issues.

Test Drive: “Boards have to kick the tires. The current framework contemplates substantial board oversight,” said Aisha Hunt, principal at law firm Kelley Hunt, who worked with F/m Investments on its application. There is an educational hurdle for firms in adding ETF or mutual fund shares, and companies will have to perform due diligence with RIAs and broker-dealers to see whether there is demand, she said. “You want to do it to ensure you can drive asset growth and economies of scale to benefit fund shareholders.”