ETFs as a share class

The latest development which spans Europe and the US is ETFs as a share class. Listen to Stephen Carson, partner, A&L Goodbody; Ben Slavin, Global Head of ETFs, Asset Servicing at BNY Mellon and Athanasios Psarofagis, ETF Analyst, Bloomberg Intelligence, discuss the technicalities of this from both side of the pond.

This is episode 4 of Off the Record, the ETF Express podcast series, brought to you in partnership with Truss Edge, providers of front, middle and back-office software and services to ETF issuers. 

Transcript

Beverly Chandler

Hello, my name is Beverly Chandler and I'm managing editor of ETF Express and I welcome you to the latest edition of Off the Record, the podcast about all things ETF brought to you by ETF Express in partnership with Truss Edge, providers of front, middle and back office software and services to ETF issuers. All views expressed in this podcast are the speaker's own and we hope, suitably controversial. Today we're going to discuss ETFs as a share class. It's a new phenomenon that's hit both sides of the pond, so we have a nice both sides of the pond panel here today. We have Stephen Carson, who's partner at A&L Goodbody in Dublin; Ben Slavin, Global Head of ETFs, Asset Servicing at BNY Mellon and Athanasios Psarofagis, ETF analyst with Bloomberg Intelligence coming to us from New York. So I'm gonna open by just, we're gonna start with the States. So Ben, in the US, what's happened that's allowed the concept of an ETF share class to develop?

Ben Slavin

First of all, Beverly, thanks for having me on. Great to be back. Well, you really to answer that question, you need to rewind probably more than 20 years when Vanguard introduced its first share class of a, you know, of a mutual fund back in May 2001. And they launched the total stock market ETF, which is VTI, as a share class of the total stock market mutual fund. And since then they've launched dozens of other share classes using the ETF structure. And that original ETF has actually become quite a monster, with over 300 billion in assets and counting today. And so what happened back then was Vanguard not only received the exemptive relief or the approval from the US regulator, the SEC, to do it, they also filed the patent on the structure and that patent effectively allowed them to have a monopoly on this structure, really for the last two decades. And that patent has expired in May, just a few weeks ago. And that has sparked, obviously, an incredible round of interest and intrigue, certainly from the industry about where this is going to go next. Now that that share class patent and the structure that was approved extends to passively managed strategies only, not active. So there are some limitations in terms of what Vanguard was able to do. But now in the US, we saw the first attempt in quite some time to receive approval for the SEC in the wake of the the expiry of this patent. So a a US subsidiary of an Australian based asset manager, Perpetual, filed for this product back in February. But at this stage, the timing of the approval and feedback from the SEC are are really unknown at at this stage, but certainly the industry is watching very closely and there are, you know serious implications for the industry and also for shareholders in these products, where there are potential benefits and and potentially some issues that investors are going to need to be aware of, if this, you know, happens to take root in the industry.

Beverly Chandler

Thanks for that really neat summary of something that's quite complicated. Stephen, I'm turning to you to ask you what's happened along the same lines in Europe.

Stephen Carson

First of all, Beverly, thank you also for me. This is my first time being on this podcast and delighted to have the opportunity to speak with you and Ben and Athan. The landscape in Europe around this issue is very different. And you know if we take Luxembourg for example, it has been possible to have ETF and non ETF share classes in a UCITS for quite a while. It's been a feature of Amundi’s Luxembourg ETF range for for quite a long time. In Ireland it's slightly different. The central bank traditionally didn't permit ETF share classes and non ETF share classes, but following their ETF discussion paper and feedback report in 2017, the Central Bank committed to updating its UCITS Q&A to provide for a disclosure regime which would allow managers to launch products or or sub funds of UCITS with ETF and non ETF share classes. So in the time since we would have worked with Ben’s team in Ireland and our mutual client HANetf to add unlisted share classes to all of their ETF product range. And so that that probably didn't create a stir because they were unlisted classes in an ETF, but quite recently when HSBC added ETF share classes to their unlisted passive range, this created a bit of a stir because one of the implications in an Irish context to adding ETF share classes to an unlisted UCITS is that the Central Bank interprets the ESMA guidelines as requiring you to change the name of that individual sub fund to include the USITS ETF  identifier. Now I I think the Central Bank's reading of the ESMA guidelines is probably the correct one, it's I think it's an unhelpful requirement of ESMA, but I don't think the Central Bank is wrong to take that view. The CSF in Luxembourg, however, takes a more flexible approach and they allow the identifier to be used at the share class level. Now I think for most managers you could probably live with changing the name of an unlisted UCITS that you add an ETF share class to, but I can certainly imagine a scenario where you're maybe a traditional mutual fund manager you don't have ETF range, you have some flagship products, you might want to add an ETF share class to one of those products. Let's say it's it's been around for five or six years. Let's say it's a couple of a couple of billion in assets under management. It would seem a bit like the tail wagging the dog if you had to rename that product as a UCITS ETF just because it issued an ETF share class.

Beverly Chandler

So there's a sort of disparity between how Luxembourg's approaching it and how Dublin’s approaching it?

Stephen Carson

Absolutely.

Beverly Chandler

And so, Athan, I'm gonna ask you cause you cover Europe from New York, so you know both these stories presumably, what do you make of both sets of developments?

Athanasios Psarofagis

It's, it's interesting for sure. Again we'll start with the US and, you know Vanguard's the only one that has this, right, like Ben had mentioned. And it's only a matter of the, where they're growing, it's only a matter of time before they're probably the largest issuer in the US, they're closing in quite, you know, rapidly on Black Rock. Now, is it to say that this gave them an advantage? Like what, meaning would they have grown without it? I don't, I don't know, right? I think Vanguard still would be doing what they're doing. But I think there's something to be said about them wanting a patent on it and wanting to protect it, right? And I think one main thing in the US is the the tax, like the tax advantage. And now tacking this on to a mutual fund, and if you're able to I'd say push these gains out through the ETF and wash them out through the, through these what we call the heartbeat trades, it now makes the mutual fund more tax efficient, which I think is a win win for everybody, right? You now have a mutual fund that's tax efficient and you're able to tack on the ETF. Now I get that in Europe that's not necessarily a bigger, it's not really an issue, right? So where I think, while in the US it seems like it was more tax focus, I think in Europe what could happen is it's just a new way to get active back into into the market, right, which is definitely lacking compared to where the US is on active ETFs. But you see an appetite for active for sure, because like even Ben had alluded to, everyone's trying to get into the market, whether it was trying to push on this Vanguard patent, whether they're doing conversions, whether they're just launching their own ETF business. I've always been a fan of the share class, I just think it's cleaner compared to doing a conversion or something like that. But I think this will be a sort of a new entry ground for active release coming in, maybe less of a tax issue in the US. But overall I think it's bullish. I think it's just going to potentially bring more strategies to the market, keep all the distribution channels open. So overall I think it's a really positive development.

Beverly Chandler

And you mentioned there the conversions which last year I seemed to be, last two years I think I've been writing about, how just weekly and the billions that that's added to the assets for ETFs in the US. So explaining to the European audience, we know that there's this mutual funds and in America converting to be ETFs, will that stop? Is that business going to stop now, Ben?

Ben Slavin

Well, the concept of mutual fund ETF conversions has been the hot topic and we've seen that accelerate over the last 12 months or so. In our own pipeline, you know we've seen a, a, a building queue of issuers looking to to do this. And back to the earlier comment, I think it just is simply another way to get access to you know, the ETF structure, and there are lots of reasons why asset managers are looking to do that. But it is complicated and it does come with friction, both in terms of the the cost to actually do the conversion and also to the shareholders who need to provide their brokerage account information and and other implications, especially if you're a qualified planned shareholder, which is, you know, retirement accounts, etcetera. So the concept of a share class definitely provides a another access point, and potentially an easier one for both the asset manager and potentially the the shareholder as well, where again that would eliminate some of the friction around you know these these sort of conversions. That said I think there are different reasons why some managers would still go down that conversion route you know, even if this became available. And I think again back to the issue of taxes, always important, right? There are certain and many benefits that could be conveyed to those mutual fund shareholders and obviously the ETF tax benefits would could potentially hold. But the reverse situation, depending on the size, the flow, the market conditions, could create adverse tax consequences for those ETF shareholders again, if they are unable to, you know, eliminate those gains through the in-kind mechanism or there's an outsized amount of transactions in the mutual fund that that again create those tax consequences. So there's some very, you know difficult decisions for asset managers to make, should you know should this come become available. But again I think we would still again see a lot of asset managers take take advantage of the share class structure, but it wouldn't necessarily kill off the conversions.

Beverly Chandler

Stephen, obviously we don't have the that conversion business in Europe, but perhaps I could just ask you, I remember the umbrella fund, are we gonna see these sort of different structures underneath one, in within one sort of fund structure that would be available to investors in Europe?

Stephen Carson

It's an interesting point that we haven't seen fund convert ETF conversions in Europe and I I I would say there is one exception to that. I think there's a Swiss manager who did a cross-border merger of some Luxembourg funds into Irish ETF receiving funds, and that was billed as a conversion because they effectively migrated unlisted products into listed versions of those in Ireland. And and I think one of the dynamics in Europe, which is markedly different to the US market is that you you don't get the same tax benefits trading an ETF relative to an unlisted UCITS fund in Europe. Either way they're they're tax exempt vehicles so you don't have that driver, but but the advantage perhaps an ETF has over its unlisted UCITS version is just that ease of access, ease of trading. And I thought what was really interesting was a report Black Rock issued recently which showed that the newer generation of investors are consuming ETFs more than previous generations, and that's probably a factor of online or app based investing. So assuming that that trend continues, then all asset managers distributing products in Europe will have, if they don't already have an ETF strategy, will need to have an ETF strategy. And there's a couple of ways of of of developing an ETF strategy in Europe. I guess the the the standard way is to set up a an ETF platform. Now obviously Ireland is the undisputed domineering domicile for ETFs in Europe, I love the revised statistic of 67% of all European ETFs are domiciled and authorised here, so that necessarily means setting up an an Irish platform. The big challenge at the moment is that post Brexit it's quite difficult and expensive to register in the UK using the 272 process. Hopefully, common sense will prevail and a more straightforward recognition path will be introduced in the UK and that won't be an issue, but at the moment that is a challenge for new entrants. So to pick up on your point about the umbrella, Beverly, most managers who have an existing Irish platform will have it structured as an umbrella fund structure so they could add new sub funds to the umbrella as ETFs and it's, you know, it's a case of updating your offering documents to provide for unlisted sub fund dealing and then ETF sub fund dealing. Or alternatively, adding ETF share classes to existing unlisted products. But I think it's useful for listeners to know that you can have ETF and non ETF sub funds coexisting on a on an umbrella structure. The tax benefits that Irish ETFs get in terms of lower withholding rates on US source income can be, and this is subject to U.S. tax confirmation, this isn't tax advice, are are able to access the double tax treaty benefits at an individual sub fund level, which is useful if you have a a a platform with a range of unlisted and listed products.

Beverly Chandler

So, Athan, what's your take? Do you think this is going to increase the flow of assets into ETFs generally across both areas?

Athanasios Psarofagis

Yeah, I think so, whether it's natural or it's just that money being remapped over from mutual funds into ETFs, right? So someone, when you look at like DFA, for example, they were really big on the conversions, probably one of the biggest sort of funds, or you know brands, moving over. And so even though there's been flows following their conversion, a lot of it's just a big lump sum being brought into the ETF market. But overall, I I think you know, I think there's still an appetite for active. We we like to track this, something like 35-40% of the flows this year have gone to active funds in the US. So the appetite is there. I'm a big proponent of of offering, you know, more product structures, whether you know what, whatever, if you like the strategy, if you want to use the fund, that's fine. If you want to use an ETF that's fine, I like. And I think the conversions are maybe such a big deal because maybe issuers didn't want to wait for the Vanguard patent, right? They're unsure of what's going to happen, could they, could they use it? So it's like, hey, let's find another way to get into it. But I think now if if they're able to use, once I think someone figures it out, everyone will follow. And this I think what happened with DFA, DFA did it first. Then you started seeing all these other conversions. I think it just, and also internally. I've worked at issuers in the past, you know, ones that, let's say, an ETF business that was part of a larger asset manager. Sometimes you had to sell ETFs internally, right? So to get your sales people to want to use ETFs. This now gives them options. Hey, you want to use the mutual fund? That's fine. You want to use the ETF? That's fine. As long as they’re now on an equal, if the mutual fund is just as tax efficient now as the ETF, I'm a I'm a big proponent of that. So overall I think just going to bring more strategies, more optionality, which is overall a good thing. And you know I think I think like Ben had said, once we see what happens with the patent and if issuers can use it, I think it will definitely be used for sure. But I think overall a bullish development, I think I'm all for more stuff, more options for investors. And if that can lower costs on existing active funds or other mutual funds, that's also a benefit too.

Stephen Carson

Just one point I'd make on that, you know, for a long time people talked about ETFs as if that was the ETF was the strategy or the product whereas the ETF piece is merely a wrapper. And actually to to Athan's point, if if you're looking at having listed and unlisted share classes in the same product, then it sort of proves the point that actually the ETF element is a distribution channel, it's an access point, and and actually what's underneath that is the strategy of the product, whether that's passive or increasingly active.

Ben Slavin

I would agree, and I would just simply add that, you know the Holy Grail here is to be agnostic from an asset management perspective, and and the way I always think about it is you can have your ice cream and it's just a matter of whether you want it in a cone, a cup or a cone with sprinkles. But in the end it's still ice cream, and maybe there's some different charges with the sprinkles but ultimately you're getting the same content inside, and that's really what the industry has been striving for for quite some time. But back to the earlier comment comment, which is some of the issues around distribution, and again, simply because it's an ETF structure, obviously the distribution opportunity is clearly attractive given where the market is going globally. But just because it's an ETF doesn't necessarily mean anything if you don't have the right distribution, marketing, it's priced correctly, obviously the investment content fits well into the ETF, you know, share class or or, you know, or or as a sleeve under a a super umbrella. So all of those other things have to be in place, but I think you know that that concept, you know, makes a lot of sense. And then, you know, let the market ultimately decide how they want to consume that investment content.

Beverly Chandler

Do we have any idea when the SEC is going to announce on this?

Ben Slavin

Well, I'll start. I think it's fair to say it's very unclear, and at this stage we don't have much information to rely on, and it's been quite some time since there's anything in the public record, right, about where the the SEC may or may not stand on this. But I think we will start to have some information soon as these filings work their way through. I think one of the other things that is important to keep in context here is that, yes, you know this is a, this is really a critical item for the industry and being watched very closely. But it is just one of many proposals outstanding from the SEC. And where this fits on their priority queue is also unknown, so it has a lot of competition from a regulatory standpoint in terms of, you know the appetite and honestly the ability to create the appropriate framework and rule making. But we do have, you know, a little bit of insight into some of the issues from the past that would need to be resolved, which is whether or not it would apply to passive only, or passive and active? Certainly what kind of disclosure the SEC would require? You know, for example around the taxation implications for both the, you know, the unlisted and listed share class. And one other issue that has been floated and and certainly out there in some of the public record has been the SEC's focus on the allocation of expenses. So for example a a fee like a from the listing exchange, right? That would obviously apply to the ETF share class, but not the unlisted share class is a small example of trying to make sure also there's equitable allocation or fair allocation of expenses. From an asset servicing standpoint, the way I like to think about it is it's just math. So as long as we get the, effectively the appropriate rules and we'll see what happens, you know most likely we'll be able to handle those calculations. And certainly there's lots of precedent again in other parts of the world which we service. And also, even in just mutual funds themselves, which have multiple share classes and we have literally thousands of those on our platform. So I I go back to my, my ultimate prince, my underlying principle was it's just math, but we need somebody needs to give us that formula or the guidelines on how to apply it to be able to ensure that we can service the industry and, you know, meet all of the SEC or or other regulatory, you know, framework.

Beverly Chandler

Stephen, do you want to add add to that?

Stephen Carson

Yeah, you know, the European market is is very different, as we said at the outset, it is possible to have listed and unlisted share classes in UCITS products in Luxembourg and Ireland, and there's no restriction to passive or active, it it, you know, it's available across strategies. One point I'd add and going back to the tax advantage that Irish ETFs in particular have, and and maybe just explain that slightly. Irish funds which, whose shares are traded regularly so an ETF satisfies the limitation and benefits test under the Irish US double tax treaty, which happens to apply a a 15% withholding tax rate on US source dividends as opposed to 30% for, say, Luxembourg or an unlisted Irish fund. And that that's a real advantage to a passive fund with US allocations, an active fund with US allocations, it's pure alpha. So you know that's one of the advantages having an Irish ETF has. Now if you had an ETF which is relying on access to that double tax treaty benefit and it launches unlisted share classes, then I think the manager would need to be aware that there is a compliance piece around ensuring that the level of trading in the ETF class doesn't fall below the threshold that would mean your your benefits under the double tax treaty fall away. So that's just one point I think somebody would need to bear in mind if they were thinking about having listed and unlisted shared classes. Interestingly, the HSBC products who adopted this model are fixed income, so that that question I guess doesn't arise in that context.

Beverly Chandler

And Athan is what do you have to add to this? I know you've just done a paper or a study on active ETFs and we don't even know if they'll be included in this, but.

Athanasios Psarofagis

Yeah, yeah, and I should have mentioned that first, like this could be a moot point, right, if active does. Cause it seems like that's where the appetite is, and it seems like that's a big part of the asset management issue that's still finding a way to come into the market, whether through conversions, launching their own business. Again, I've always been a fan of this cause it seems the cleanest way, but you know like Ben said, there's still a lot of unanswered, you know, things that need to be figured out. Like for example the ETF rule, which passed like in 2019, share class ETFs were left out of that. So now if I am an asset manager, I create a share class, am I part of the rule, am I outside of the rule? So there might be the secondary filings or petitions need to come in after if you want the advantages of the rule. So I think you know the SEC's dealing with a lot, you know with crypto ETFs and things like that. So I don't know again where this ranks on their, you know on their list. But uh, you know, I'd like to think even if this doesn't happen issuers will find another way to get into the market. But I I just think this seems like a pretty easy way. You have your existing fund, you tack this on, you, you start making it more tax efficient, you keep your distribution channels open. So, no I think they, I think both did a great job of covering everything. So I I think you know, I've heard rumblings, you know, of a lot of demand for it or, but you know we're we're still waiting to see what's actually going to happen.

Beverly Chandler

It's going to be interesting. I hadn't realised Perpetual was an Australian firm, so that's interesting as well, that its not domestic US coming in to do, to shake everything up. I'm gonna say I think we've covered that subject thoroughly. I'd just like to thank you all for being here. Thank you to my guests. So Ben Slavin, Stephen Carson and Athanasios Psarofagis. This is this outing of Off the Record from ETF Express, in partnership with Truss Edge providers of front, middle and back office software and services to ETF issuers. Thank you so much and I hope you enjoyed listening.

Outro

Off the Record is brought to you by ETF Express in partnership with Truss Edge providers of front, middle and back office software and services to ETF issuers. Production by Imogen Rostron and Lisa Hines and music by Otto Balfour. Thank you to our guests on this episode of Off the Record from ETF Express, and to you for listening. We look forward to you joining us next time.