How the ‘Domino Effect’ from a Wonky SEC Policy Shift May Ease Capital Gains Pain

Our story begins in 1993, when exchange-traded funds were introduced to the US market. They generally operated as standalone products until something changed, on a relatively small but increasingly important scale, in 2000.

That’s when the Securities and Exchange Commission let investment management firm Vanguard create a dual-class model.

Instead of separate funds, Vanguard took an existing mutual fund and added an ETF version as a different share class. That way, the mutual fund and the ETF shared the same portfolio. Investors who wanted a piece of the fund could then choose how they wanted to interact with it. 

Vanguard patented this “ETF-as-a-share-class” concept in 2001, but patent protection expired in 2023, clearing the way for more fund managers to seek SEC approval for their own dual-class funds. The agency has, in recent months, encouraged them to do so.

According to J.P. Morgan Asset Management, over 90 asset managers, including some that don’t currently have ETF businesses, have sought permission from the SEC to do the same as of March. Some 48 firms have been approved.

The first was Dimensional Fund Advisors, to which the SEC granted permission to launch ETF share classes of 13 of its mutual funds in November 2025. F/m Investments, an $18 billion, Washington, DC-based fixed income manager, beat Dimensional to the market, however, touting itself as the first non-Vanguard firm to properly launch a dual class fund in February.

One big benefit for investors is that the new fund structure opens up a different way to manage tax liabilities. 

Mutual Pain

Mutual funds and ETFs are well known to active investors and Americans managing for retirement alike. They offer a simple, straightforward way to invest in publicly traded companies and bonds by pooling money to put in a diversified basket of assets. Those baskets can also include digital assets and illiquid securities, such as private companies, though usually at limited caps.

There are notable structural differences. ETF shares trade throughout the day on stock markets, while mutual fund transactions occur at market close, usually through intermediaries such as broker-dealers, financial advisors and banks.

They have unique methods for handling investments and withdrawals, too, which have major effects on holders’ taxes.

When a mutual fund needs capital to pay departing investors, it will often sell some of its investments to raise cash. If those investments have increased in value, that creates a capital gain.

When mutual funds realize capital gains, they are required to distribute them to current shareholders. That means even investors who didn’t opt for redemption will get a capital gains distribution. When that happens, those investors are on the hook for capital gains taxes, whether they sold or not. This can be a pain, both in terms of investment planning and annoying paperwork.

The reason things work this way is that mutual funds are typically set up as Regulated Investment Companies, which requires them to distribute 90% of income and realized capital gains to shareholders. They generally don’t pay income tax on gains because they pass them along to you.

ETFs, while often Regulated Investment Companies, too, operate differently. When ETF investors exit, they sell their positions to other investors on the stock market. That doesn’t create a taxable gain for other fund investors. ETFs also use in-kind transactions, a type of non-cash swap in which securities are exchanged. When a big investor exits and wants to redeem their ETF units, the fund can give them underlying stocks, which doesn’t trigger capital gains.

Dominance vs. Growth

That’s not to say ETFs don’t come with their own tax liabilities. When you sell ETFs at a profit or receive dividends from them, Uncle Sam still comes calling. But you mostly pay taxes on ETFs only then.

Mutual fund taxes, to emphasize the point, can happen in any year and vary depending on realized capital gains. Even for shareholders who don’t sell. In sum, ETFs prove more tax-efficient because shareholder activity can take place without the need to sell fund holdings. 

That may help explain the massive preference investors have shown for ETFs in recent years. There are other reasons for their comparative popularity, too. Not only have mutual funds traditionally had higher fees than ETFs, but ETFs are also seen as more transparent, since their full underlying investments are disclosed.

ETF inflows exploded to $1.5 trillion last year, easily besting the $1.15 trillion record set in 2024, according to State Street Investment Management. US mutual funds, meanwhile, suffered more than $550 billion in net outflows in the first 11 months of the year.

Mutual funds remain a significantly larger piece of the $44.9 trillion fund industry, however. According to the Investment Company Institute, they held about $31.4 trillion in net assets last year; that compares with $13.5 trillion for ETFs.

Billion-Dollar Takeaway

Dual class funds, advocates say, will offer significant benefits to investors in mutual funds and ETFs alike. Mutual fund holders gain access to the ETF share class structure and improved tax efficiency; trades can be made under the ETF share class, for example, without causing a capital gains event. ETF holders, on the other hand, can buy into mutual funds with scale and proven track records. More investors pooled into a single fund can also reduce overhead and result in lower fees for everyone.

SEC Chairman Paul Atkins argued in a February Washington Post op-ed that bringing in more dual-class funds would help a significant number of ordinary Americans. He cited Investment Company Institute figures estimating that mutual funds distributed $175 billion in capital gains in 2024, and noted that 54% of US households hold mutual funds, representing nearly a quarter of their financial assets.

“With a small yet meaningful structural change, the SEC has delivered a major tax break to millions of people investing to build wealth,” he wrote.

There are also major implications for the industry. Some have suggested that an explosion in ETF launches could rapidly accelerate the decline of the already-shrinking mutual funds sector, though many major issuers say there’s little evidence that’s happening yet.

One reason may be infrastructure. “Despite the dual-class structure’s growth potential, operational integration and regulatory compliance pose challenges,” wrote Jon Maier, the chief ETF strategist at J.P. Morgan Asset Management. There is no “automated, industry-wide mechanism for mutual fund-to-ETF share exchanges,” which “forces administrators to rely on manual workflows,” he noted.

Domino Effect: “While many distributors may initially hesitate to build out these capabilities, there may be a domino effect: Once a few key players establish a footprint, others could follow,” Maier added.

And if it’s key players who could spur a sea change, several big names have lined up to get dual-class structure approval.

In addition to the aforementioned Dimensional Fund Advisors, the largest active ETF manager in the US, the SEC has also given the green light to BlackRock, JPMorgan, Fidelity and State Street.

Death, taxes and, as Marvin Gaye pointed out in 1972, trouble, are certain in life. Usually, so is Wall Street firms of that caliber getting their way.