Flipping the script on the notion of offering an ETF share class of a mutual fund, F/m Investments LLC (“F/m”) this week filed an application (“Application”) with the SEC to permit its passive Treasury ETFs to offer a mutual fund share class. F/m’s filing comes on the heels of a recent filing by Dimensional Fund Advisors, which sought to build upon long-standing but unique ETF share class relief obtained by Vanguard two decades ago.1
Mutual funds wishing to offer an ETF share class, or, in F/m’s case, ETFs wishing to offer a mutual fund share class, require exemptive relief because Rule 6c-11 under the 1940 Act does not provide relief from Sections 18(f)(1) or 18(i) of the 1940 Act, nor does Rule 6c-11 expand the scope of Rule 18f-3’s multi-class relief to permit a single fund to offer both an ETF class and a mutual fund class. In the 2019 release adopting Rule 6c-11,2 the SEC expressed concern that a mutual fund with an ETF share class that transacts in-kind with authorized participants may give rise to differing transaction costs to shareholders of the different classes. Absent a mechanism for allocating transaction costs solely to the appropriate class(es), all shareholders would generally bear these costs. Similarly, an ETF share class of a mutual fund, through its in-kind creation and redemption process, would provide tax benefits that would accrue to all shareholders, including mutual fund shareholders who acquire shares directly from the fund in exchange for cash. Because of the significant differences between traditional ETFs and mutual funds with an ETF share class, the SEC excluded share class ETFs from the scope of Rule 6c-11. F/m’s requested relief raises similar issues – a mutual fund share class of an ETF will benefit from the tax and transaction cost efficiencies of the ETF share class. F/m’s Application argues that absent relief, its Treasury ETFs will be left without access to the sizeable 401(k) market, for which mutual funds are particularly well suited.
Having a mutual fund share class of an ETF raises certain issues, including potential cross-subsidization among the share classes, particularly with respect to transaction costs. However, F/m argues that the ability to manage a single vehicle that offers both mutual fund and ETF share classes would be beneficial to all shareholders. The multi-class structure will allow each investor, including retirement plan investors that typically do not have access to ETFs, to choose the manner in which they wish to invest in a fund based on the share class characteristics that are most important to them, while enjoying the benefits of efficiency and scale in a combined vehicle.
Similar to Dimensional’s proposal, the F/m Application would rely on a fund’s board of directors to assess, both initially and periodically, whether the multi-class structure is in the best interests of each ETF class and mutual fund class individually and of the fund as a whole, as well as whether the multi-class structure is operating effectively. To inform these assessments, the board would review data regarding brokerage and other costs associated with portfolio transactions, cash levels, and taxable distributions for the fund and each share class and evaluate potential conflicts between the classes. Further, the fund’s registration statement also would clearly describe the multi-class structure, including any associated risks, such as the potential for cross-subsidization of portfolio transaction costs and sharing of tax benefits.
One significant difference between F/m’s request and the earlier requests by Dimensional and Perpetual, as well as the long-standing Vanguard relief, is that F/m would offer a bilateral exchange privilege, meaning mutual fund class shareholders could exchange their shares for ETF class shares, and ETF class shareholders could exchange their shares for mutual fund class shares. Vanguard’s relief only permits mutual fund shareholders to exchange their shares for ETF shares, and not the reverse. The Dimensional and Perpetual applications also contemplate only mutual fund for ETF share class exchanges. This bilateral feature requires exemptive relief under for two reasons. First, Rule 6c-11 requires ETF shares to be listed on a national securities exchange, and mutual fund class shares of an ETF would not be listed on an exchange. Second, mutual fund class shares would be exchangeable directly for newly issued ETF class shares, and vice versa, while Rule 6c-11 requires that ETFs issue and redeem shares at their net asset value per share (“NAV”) only to authorized participants in creation unit aggregations.3
Observations. F/m’s Application presents the staff of the SEC (the “Staff”) with a novel request – permit an ETF to offer a mutual fund share class so that the ETF can access the 401(k) market. F/m argues that the potential benefits to all investors of allowing a mutual fund share class of its ETFs outweigh any concerns regarding cross-subsidization due to the unique nature of the highly liquid U.S. Treasury markets. In particular, F/m notes that transaction costs and tax consequences in connection with purchases and sales of U.S. Treasuries are minimal, and that the transparent nature of its ETFs and the depth of the markets in which they trade present minimal risk of front-running. Significantly, the Application will only apply to F/m’s suite of Treasury ETFs. The Application also contemplates board oversight that may address the concerns about cross-subsidization articulated by the SEC in the Rule 6c-11 adopting release, but does not address how swing pricing, if required, would apply to a mutual fund share class of an ETF. Given the novel relief requested by F/m, we expect that applicants seeking similar relief will need to engage with the Staff to work through the issues raised by the proposed structure.
We continue to believe that the ability to offer investors the choice of an ETF share class and a mutual fund share class in the same vehicle would provide significant benefits to shareholders, and we look forward to helping clients work through the issues potentially raised by these proposed share class structures. Asset managers may wish to open a dialogue with the SEC Staff to ensure that the Staff hears their views on these issues should the SEC determine to grant some version of the relief.
If you would like to learn more about the issues in this Alert, please contact your usual Ropes & Gray attorney contacts.
- The Ropes & Gray Alert on the Dimensional filling, including a discussion of the concerns regarding ETF share class relief articulated by the SEC in the adopting release for Rule 6c-11, can be found here: https://www.ropesgray.com/en/newsroom/alerts/2023/07/dimensional-fund-advisors-files-for-exemptive-relief-for-an-etf-share-class. The Ropes & Gray Alert on the earlier Perpetual application can be found here: https://www.ropesgray.com/en/newsroom/alerts/2023/02/applicant-files-for-vanguard-type-etf-as-a-share-class-exemptive-relief.
- The Rule 6c-11 adopting release is discussed in a 2019 Ropes & Gray Alert.
- Rule 6c-11(a)(2) provides: “Notwithstanding the definition of exchange-traded fund in paragraph (a)(1) of this section, an exchange-traded fund is not prohibited from selling (or redeeming) individual shares on the day of consummation of a reorganization, merger, conversion or liquidation, and is not limited to transactions with authorized participants under these circumstances.” While the contemplated exchange privilege does not fit squarely within this provision, this provision shows that the SEC has acknowledged that there are circumstances under which it is appropriate for ETFs to issue or redeem shares in other than creation unit aggregations.
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