A Vanguard Style Fund Rush Arouses Warnings on Wall Street

Exchange-traded funds (ETFs) have surged in popularity over the past few decades by offering investors a combination of tax advantages, lower fees, and greater liquidity compared to traditional mutual funds. These features have allowed ETFs to accumulate trillions of dollars in assets.

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However, a potential regulatory change could blur the lines between ETFs and mutual funds — and possibly threaten the very traits that fueled the ETF boom in the first place.

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The U.S. Securities and Exchange Commission (SEC) is expected to approve a long-awaited proposal that would allow asset managers to create dual-share-class structures. This would enable existing mutual funds to add an ETF component, giving investors the option to choose how they access the same underlying investment strategy.

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More than 50 asset managers, including giants like BlackRock Inc. and State Street Corp., are waiting for the SEC’s go-ahead. This shift became possible after Vanguard’s exclusive patent on this dual structure expired two years ago.

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This hybrid setup presents a tempting opportunity for firms eager to enter the ETF space without the need to develop entirely new strategies. It could also serve as a lifeline for companies that have seen massive outflows from their mutual funds, as investors increasingly gravitate toward ETFs for their efficiency and tax benefits. Vanguard itself used this model to help its clients save billions of dollars in taxes over a 20-year period.

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Still, replicating Vanguard’s success might not be easy. Industry veterans caution that the changes could dilute some of the key benefits ETFs are known for — especially during periods of market stress when outflows spike. One of the major concerns centers around the possibility of capital gains being passed on to ETF investors, something ETFs typically avoid.

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Brandon Clark, director of ETF business at Federated Hermes and a former leader in Vanguard’s ETF capital markets team, noted this potential drawback. “In 20 years, we’ve talked about how ETFs avoid capital gains distributions, but people may not realize how the new hybrid structures could reintroduce that risk,” he said.

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The issue stems from fundamental differences in how ETFs and mutual funds handle redemptions. ETFs typically use an “in-kind” redemption process, where securities are swapped with authorized participants instead of being sold, avoiding the need to realize capital gains.

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Mutual funds, on the other hand, redeem shares in cash, often forcing managers to sell holdings. This can trigger taxable gains, which are then distributed to investors. If a mutual fund within a hybrid structure experiences heavy outflows, those gains could spill over into the ETF share class, defeating one of its key advantages.

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According to Bloomberg Intelligence analyst Eric Balchunas, ETF holders may not face problems if the mutual fund side sees steady inflows or balanced flows. But in scenarios involving significant withdrawals, the tax burden could be shared across both share classes. Cerulli Associates found that around two-thirds of ETF issuers they surveyed flagged this potential “spillover” risk.

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There is precedent for this concern. In 2009, a Vanguard fund had to distribute a 14% capital gain across both its mutual fund and ETF share classes after a large mutual fund redemption. Though rare, the incident highlights the tax complexity that could arise if such hybrid structures become common.

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Some observers argue that current investors in a mutual fund could benefit from the addition of an ETF share class, as it may improve overall tax efficiency. Ben Johnson, head of client solutions at Morningstar, suggested that these investors stand to gain immediately.

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However, financial advisory firms like UBS Group are carefully evaluating the potential risks before including such funds on their platforms. Mustafa Osman, who leads fund due diligence at UBS, warned that ETF investors could find themselves unexpectedly on the hook for tax distributions.

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The SEC is requiring applicants to address these risks — especially the issue of “cross-subsidization” between share classes. Some firms, like Dimensional Fund Advisors, have already updated their filings to include governance plans that outline how they’ll monitor and manage this risk. These include regular assessments of portfolio liquidity, cash levels, and unrealized gains.

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The broader ETF market is also facing more frequent capital gains distributions, driven in part by ETFs that track rapidly appreciating assets or use derivatives. In 2024, roughly 5% of passive ETFs and 12% of active ETFs paid out capital gains — the highest figures in several years. Mutual funds, by comparison, remain far more likely to distribute gains, with over half doing so last year.

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There’s also a financial impact for fund platforms. Cerulli estimates that brokerage firms and wirehouses could lose up to $30 billion in revenue if assets shift from mutual funds to ETF share classes. This may prompt firms to negotiate new revenue-sharing agreements with ETF providers, which could ultimately increase costs for investors.

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Lastly, liquidity — another hallmark of ETFs — may also be at risk. Cerulli researchers warn that hybrid ETFs that fail to attract significant assets could experience wider bid-ask spreads, raising trading costs. Smaller asset managers, in particular, might struggle to manage these challenges without the robust infrastructure and liquidity support enjoyed by industry giants like Vanguard.

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In short, while the move toward hybrid mutual fund-ETF structures promises new opportunities for both fund companies and investors, it introduces a range of risks and uncertainties. Whether the benefits can be preserved without compromising the core appeal of ETFs remains to be seen.

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