The SEC approved the first dual share classes of ETFs and mutual funds this week, meaning advisors won’t have to choose between the two wrappers, effectively letting them order the surf and turf.

Dimensional Fund Advisors on Tuesday received the long-awaited exemption, which could become one of the Securities and Exchange Commission’s most significant decisions since the ETF Rule in 2019. Almost 80 other companies, including major asset managers like BlackRock, State Street and JP Morgan, are still waiting in line for the green light. While the eventual benefits of the decision may take years to develop, experts agree it’s a major milestone for the industry that could reshape how financial advisors use the funds inside client portfolios. Plus, nobody likes choosing between the steak or the lobster.

“We anticipate Dimensional will be the first firm to offer an actively managed ETF share class of an existing mutual fund,” said Todd Rosenbluth, head of research and editorial at TMX VettaFi. “Demand for actively managed ETFs has never been stronger.”

Can I Wrap That Up?

For advisors, new products that utilize dual share classes will likely blend the advantages of the ETF wrapper with the scale and reach of traditional mutual funds. They could also help ETFs enter the 401(k) landscape. Dimensional, one of the country’s largest active ETF issuers, can now extend key ETF features to existing mutual funds, like the creation and redemption mechanism that can help boost tax efficiencies.

Dimensional had applied to add exchange-traded fund share classes to 13 of its US equity funds, according to a release. Some of them include:

• The firm’s flagship strategies such as the US Core Equity 1, US Small Cap Value, Vector Equity and its Real Estate Securities Portfolio.
• Dimensional has 41 ETFs in total with over $225 billion in assets under management.

Managers still have their work cut out for them, however. The challenges will be navigating the significant back-office reporting issues and ensuring investors fully understand the structure, Rosenbluth added. “Gaining approval for an ETF share class and successfully launching one are two different things,” he said. Dimensional said the first batch of selected funds were the least operationally complex to transition, but additional candidates are expected to follow. “We expect many other asset managers will observe this rollout carefully before adopting a similar approach,” Rosenbluth said.

I’ll Take Two: There will certainly be winners and losers. Historically, the easing of regulations has tended to favor the biggest brand names, said Aniket Ullal, head of ETF Research & Analytics at CFRA Research. For example, after the ETF Rule went into effect, almost 60% of active ETFs assets went to just five issuers, though it could also benefit boutique managers with strong track records. “Mutual fund managers who lack both strong brand recognition and a track record of past performance will likely face a twin threat: downward fee pressure and difficulty in attracting ETF inflows,” he said.

Collateralized debt obligations got a bad rap from movies like “The Big Short.” But the story could be different for their cousin, collateralized loan obligations.

Issuers are diving into the world of exchange-traded funds that invest in CLOs. Janus Henderson recently filed with the Securities and Exchange Commission to launch another CLO strategy, while Reckoner Capital Management proposed four such ETFs earlier this month. The appeal stems from their high yields relative to other bond funds and the recent period of high interest rates. The new funds also reflect investors’ appetite for risk-on strategies as more of these products enter the arena.

“During that rising rate period … [CLO ETFs] just happened to stand out as an asset class that people thought was interesting,” said Paul Olmsted, senior analyst of fixed income strategies at Morningstar. “It’s a yield play.”

CLO Clones

The new Janus fund will invest in AA- and A-rated CLOs, which are higher risk than AAA bonds (that have never defaulted) but could also potentially yield higher returns. Janus Henderson was the first to offer CLOs in an ETF wrapper, launching JAAA in 2020 and giving investors access to a broad array of collateralized loan obligations, or investments in companies that make loan payments; investors see yield when the corporations pay off their debts. Other funds from BlackRock (CLOA) and VanEck (CLOI) hit the market in 2022 and 2023, respectively.

The three largest CLO ETFs available today include:

• Janus Henderson’s AAA CLO ETF (JAAA), which has roughly $25 billion in assets and is up 3.8%.
• The PGIM AAA CLO ETF (PAAA), which has $4.5 billion in assets and is up 4.3% year to date.
• The iShares AAA CLO Active ETF (CLOA), which has $1.3 billion in assets and is up 4.2% year to date.

Go With the CLO: The recent surge of CLO strategies may also stem from a growing interest in private credit, and the expansion of institutional-grade investments to retail investors. Still, there is always some risk involved in CLO investments, particularly lower-grade loans (like BBB or BB loans), even if corporations are the ones paying the loans. Olmsted advises to “stick with the bigger ones.”

“It’s so important that people are doing their due diligence,” Olmsted said. “If you look at some of the smaller names out there, just be aware and make sure that they have a reasonable track record.”

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.”