ETF share classes for munis remain a long way off

Use of exchange-traded fund share classes is a long way off for the muni market, market participants say, despite the Securities and Exchange Commission’s recent approval of Dimensional’s application for using the structure.

Of the 80-plus applications filed for exemption relief to offer ETF share classes — which is a way to offer ETFs as an option for investors in existing mutual funds — some mention muni mutual funds, like Nuveen, AllianceBernstein and BNY Mellon. However, observers say this is a strategy to include as many options as possible in the application, as it is challenging to return to the SEC to amend the submission.

“It makes sense strategically to throw as much into that exemptive application as you can get because it doesn’t obligate you to ever launch those products, but it gives you that flexibility,” said Ben Slavin, industry head of ETFs at BNY, who did not share the firm’s 40-APP/A application.

The ETF share class offers a way to invest in the same underlying assets, benefiting from the ETFs’ potential for tax efficiency and intraday trading. This structure enables different trading and tax characteristics, allowing asset managers to expand their product offerings without launching an entirely new fund.

Prior to Dimensional’s approval, only Vanguard held a patent to the ETF-as-a-share-class structure, but the patent expired in 2023.

Vanguard’s patent expiration, along with the exclusion of ETF share classes from Rule 6C-11, led to a surge in SEC exemptive relief filings by ETF and mutual fund issuers, including this year, some of which were refiled after Dimensional’s approval to mirror its language.

The approval of ETF share classes will be a “slow-moving avalanche,” rather than an explosion, as equities are likely to go first, followed by fixed income, Slavin said.

“Anybody who currently manages a muni ETF and has a muni mutual fund and gets their application approved will clearly be in a better position to move quickly,” he said.

However, those without ETF operations would need to establish one. It’s not as simple as “turning it on because you need to have the right connectivity and your process and operating model in place to launch any ETF, whether it’s a muni or an equity ETF,” Slavin said.

The market is waiting to see what asset managers will prioritize in terms of adding an ETF share class to their existing mutual fund lineup, but munis, as with most of fixed income, are not the priority for most firms, said Tom Murphy, a senior manager research analyst at Morningstar Research Services.

Since adding an ETF share class could improve the tax efficiency of a mutual fund, the initial impact will be on mutual funds that have a lot of built-up capital gains. This, though, doesn’t really apply to munis funds, which don’t typically distribute capital gains and are tax-efficient in nature, he said.

At some point, there could be ETF share classes available for muni funds for distribution, sales efforts and/or in an attempt for firms to retain or grow assets available in their mutual fund vehicle, but it’s still a long way away, Murphy said.

However, muni funds may not be as far away as some think, said Pat Luby, head of municipal strategy at CreditSights.

With Dimensional leading the way, the addition of ETF share classes is “on the radar screen.” The floodgates may start to open at some point, though it’s likely to be a trickle at first, Luby said.

The specific products, as with all issuers, would have to be considered on a case-by-case basis, Slavin said.

Each fund would have to be considered separately and ultimately — as part of the governance mentioned in all these exemptive applications — and would need approval for any such offering of a share class, he noted.

Even after receiving approval — which not everyone is — it’s not a “slam dunk” to quickly get it ETF share classes done because of operational challenges, Luby said,

For example, there’s not yet a broadly accepted blueprint of how these would work, whereas the launch of an ETF or mutual fund has “plumbing in place,” and everybody understands all the participants that touch those products, he noted.

There may also be questions about how ETF share classes will be handled on the broker-dealer distribution platforms, Luby said.

For one, it’s unclear whether the solicitation of ETF shares with a significantly lower cost structure will be allowed, as compliance procedures will need to be established, he said, and determining which product is most suitable for each client will require careful consideration.

ETF share classes are not appropriate for every mutual fund, Slavin said.

Firms view this as a asset in their product development toolkit, as ETF share classes are a factor that will inform their ETF strategy, he noted.

At some point, ETF share classes will be a significant development for the muni market, as they increase the number of ETFs investors can choose from, Luby said.

It may also reduce the pressure on managers to feel they have to convert their open-end funds into ETFs, though conversions will still happen, he said.

“This can only obviously mean that there will be more ETFs in the market, and assets will flow, either because you’re attracting new assets or allowing the conversion of existing assets,” Slavin said.