Nicsa webinar: Board Considerations: Fiduciary Duties and Decision-Making in ETF Dual Share Adoption

Hello, and thank you for joining NXA's webinar Wednesday. My name is Natasha Bush Postel, and I am the webinar program manager. And on behalf of NXA, I'd like to welcome you to today's program. Today's webinar is titled Board Considerations, Fiduciary Duties, and Decision Making in ETF Dual Share Adoption. This program is sponsored by Broadridge. We thank them for their support and for bringing this valuable content to our members. Before we begin, I'd like to address a few housekeeping items. 

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Key takeaways can be gathered, but we ask that no one person or firm is attributed with specific quotes. Members of the press can be contacted at info at nixit . org for any follow -up information. Thank you and enjoy today's program. At this time, I will turn it over to today's moderator, Jeff Turnahoy. Jeff is the Senior Director at Broadbridge. Jeff. Thank you, Natasha. Thanks, everyone, for joining us today. And I'm going to introduce our panelists for today's discussion. I'm joined by my colleague, Corey Lewandowski. Corey is a Client Success Manager at Broadridge. He manages client relationships and advises on all aspects of the 15C advisory contract renewal process at Broadridge. We are also joined by Carolyn McPhillips. She is the President of the Mutual Fund Directors Forum, where she plays a pivotal role in developing and expanding MFDF's resources for independent fund directors. And we're also joined by Elizabeth Marchetti, Senior Director at SEI, where she leads SEI's capital markets and specialist support and provides guidance around ETF mechanics, trading best practice, workflows, and capital market strategy. So thank you to all of our panelists today and thanks to the audience for what I think is going to be a very fulfilling discussion and we hope we get a lot of audience participation as well.

Now to kick things off, how did we get here with ETF dual share classes? Broadridge has put together a couple of slides here to give us a little background. We're not going to run through all of them unless we need to as reference later on. But when we talk about the ETF share class, there's a couple of key key industry developments along the way, starting back in 1993, when SPY was the first ETF to hit the US exchanges listed as SPY. Now, a lot of things happened in between then and 2019, but that I think is another watershed moment where the SEC adopted the ETF rule, which streamlined the process for approving new products, and I think accelerated the product innovation and introduction of new funds and interest new asset classes to the market. And we move along a little bit farther and now we're in 2025. This is where the ETF dual share class was approved for DFA. Now, why is it so important? Well, historically, the last couple of years has been a momentous one for ETFs.

In terms of assets and flows, they're really soaking it up right now. Passive ETFs continue to be the foremost investment choice for investors. Active ETFs are also gaining a lot of traction out there. Simultaneously, active mutual funds have been on the decline as far as flows are concerned. For a number of years, we've seen outflows from mutual funds, particularly active ones. And so active ETFs are a natural response for the industry to try to claim some of those flows. Now, we certainly still have a majority of assets in the funds industry located in mutual funds, so they're certainly not going away anytime soon. But when we look at some of the reactions from advisors that we've talked to and asked, where do you see the future direction of funds and ETFs heading? About 54 % say they're going to replace some of their clients' mutual funds with ETFs over the next couple of years. 35 % think that they'll replace most, if not all of their client assets with ETFs. So certainly a powerful area for development over the next couple of years. the industry can sort of sense that their major distributors and partners are moving towards ETFs. And if there's any way to kind of soak up some of that energy through the use of a dual share class, offering an ETF share class alongside the mutual fund, that may help start to turn the tide toward back into some of those mutual fund products by way of an ETF share class. With that, let's start to turn our attention back to the major considerations we're going to have in this discussion. So first off, we want to talk about suitability. Are these products ready for every single advisor out there? Are they ready for every client? We'll also look at some other areas such as fiduciary duties. 

What is it that the board should be aware of when discussing the ETF share class with management? We'll also touch on distribution. There's a lot to be done on the distribution side of things to ensure that these products hit the market as seamlessly as possible, knowing already that a lot of the plumbing for the industry is just not quite ready on day one at this point. So we'll get into some of those details as we move forward. So in fact, if I can start it off with Elizabeth, we've talked a little bit, we've gotten a little bit of background on the difficulties of the ETF as a share class, thinking in terms of suitability. If you could give us maybe a bit of a background bit more detail about the basic overview for our attendees. Maybe some of those don't already have some direct oversight of ETFs. What are some of the issues that they may be facing? Yeah, thank you so much, Jeff. So I kind of want to start with two, excuse me, fundamental ideas about ETFs in general, which I think will end up being sort of my chosen soapboxes for the duration here. But important ETF history, and especially to the extent that your firm isn't currently managing them or is really planning to make your entry into ETFs via potentially this share class concept. 

First, I think it's super important to understand that ETFs, which have now been around for over 30 years, were not actually the innovation of the investment management industry. They were really more the invention of the street. Basically, the street was kind of at the intersection of a boom in portfolio or program trading and index -based investment concepts. And the ETF, by bundling those baskets into a fund or the fund as a format would allow you to trade them on the secondary market at market determined prices. The street basically created another layer of trading for itself and another sort of P &L opportunity for market making. Over time, and I think interestingly, especially in the last five or six years, that association with efficient trading of passive concepts has really given way to the tremendous boom in active asset managers packaging their capabilities through ETFs. But it's really important, and I really don't think we can overstate the importance of the market -making community and making the ETF part of this equation go. Secondly, and a related idea, is that tax efficiency is not a magical feature of the ETF as a wrapper in and of itself. And this will spend a lot of time on the notion of the ways that the ETF share class could conceivably be disadvantaged by its presence in now kind of shared space with the mutual fund. But it's important to understand, and in my seat, we spend a lot of time educating asset managers on what tax efficiency means. It's not that the ETF is magically tax efficient. 

It just means that the way that ETFs are created and redeemed, the way that capital flows into and out of an ETF in a process intermediated by what's called authorized participants, enables an ETF to take advantage of in -kind redemption. So it's not that, you know, so in the language and all the enthusiasm about share class, we talk about, oh, now the broader structure could rebalance in a much more tax efficient way, thanks to the in -kind mechanism. It's not that when you go to rebalance an ETF, you simply exchange Google for Apple or whatever it is. It's that capital can come into the ETF and when that capital leaves the ETF, you can deliver out without effectuating a market sale and thus realizing potentially capital gain. you can relieve those shares through the redemption mechanism. So again, it requires capital coming into the fund in order to leave it for that tax efficiency to be realized. So when we think about suitability, I think there's two dimensions that are extremely important. First, and really less, so there's suitability in the sense of, is this strategy a fit for the ETF as a continuously traded structure. Second, is this project overall suitable based on what I'm trying to get out of it? And I will say if tax efficiency is a goal, that's fine. But if tax relief for the mutual fund is the predicate of the whole interest, I think that's where we need to take a step back and really kind of understand two things. First off, are the underlying assets in your ETF unkindable? I think, you know, if you get to the, you know, get deeper into the weeds around ETFs, you realize, A, not everything is exchangeable and kind. So if, for example, you have, you know, an ETF that is concentrated heavily in emerging markets, so -called ID markets. Many of those markets cannot be exchanged in kind and thus are not eligible for the type of tax relief that we rely on through the in -kind mechanism. 

Second, do you have the relationships in place with the street that would motivate a market maker, an AP, for example, to come in and through that ETF mechanism, really amplify that tax benefit across the now shared structure overall. So I think, again, to the extent that tax efficiency is the overarching goal or that tax relief for the the existing mutual fund is the primary driver of this project. That is where I think suitability is going to be a really, really important focus within the tax conversation in particular. You got me worried now. I'm not so sure this is going to be an easy fix. So in fact, if I could have Carolyn chime in a little bit about Vanguard's own exemptive relief application, what does that mean for the rest of the industry? What have we been using that for? Where's it go? Yeah, I mean, I think it's an interesting issue because they had a patent actually on the ETF share class that just expired, which explains the recent interest from other firms and getting into an ETF share class. So because of the patent, no one else was able to offer the products. However, I will say that The ETF share class that Vanguard has is quite different than what we're talking about today. Those ETF share classes are only on passive funds. They are not on active funds. The SEC never did grant the exemptive relief to allow Vanguard to use their patent on actively managed funds. And further, The Vanguard patent and ETF share class allows them to have a non -transparent portfolio. That is not what is contemplated in the current ETF share class application. So, in the current stable of applications, including the DFA application that the SEC is going to model the rest of the applications after, they are required to have transparency in the portfolios because they're required to follow the ETF rule, which you mentioned earlier, Jeff, from 2019, that does require portfolio transparency. So the question is, what is going to happen to the current ETF share classes, I think that's an open question. Historically, the SEC has not really liked to revoke exemptive relief. However, they have done it from time to time in the past. So I think nobody exactly knows what the path forward, but we do know that the path for other complexes is certainly going to require this portfolio transparency, at least in the current crop of applications that are before the SEC. 

Okay, gotcha. So I'd like to open it up to the audience for our first poll question. And we're gonna tip this back to Corey in a moment about some funds that may not benefit from conversions. But if we're gonna ask the audience right now to think about their interaction with their boards, specifically, we'll just raise the question right here on a scale of one to five, how prepared is your board for discussions around that ETF dual share class? Have you guys been thinking about it? Are the discussions ongoing? Would you characterize it as not at all prepared? Are they interested? Are they talking about it? Do you think that your board is currently ready to go? day one where we've already, I mean, maybe they don't have all the issues ironed out, but they're talking in great detail, asking pointed questions of management, how to engineer an ETF dual share class. We'll just keep this open for a few moments as we kind of get a flavor for how everyone's positioned with their board on this subject. I was thinking, Corey, though, do you think there are some strategies that just probably wouldn't benefit from a dual ETF share class? Yeah, thanks, Jeff. Um, yeah, certainly, we certainly talked about, you know, in terms of the the right fit, right. And that's, to Elizabeth's point, that's, that's pretty loaded in terms of right fit. But when you when you think of certain strategies, whether it's, you know, capacity constrained, concentrated strategies, liquid strategies, some of those might be The considerations that are really at the forefront of whether or not yeah that that makes sense for conversion, there's, I'd say beyond that there's there's a lot of other considerations to write like a path to success so assuming you know the the infrastructure and operational readiness readiness that we talked about already in place. and even taking kind of the fee competitiveness out of the equation due to maybe larger incumbents that are in the space, success is going to kind of hinge on factors such as performance track record, differentiation, innovation, those types of things. 

But additionally, in a big part of the ETF share class is going to be really kind of what is our addressable market as a fund? Right, so based on our current distribution dynamics of the fund, where is our opportunity? So if we are within channels X and Y, how do we position sales teams, distribution partnerships to better access the investor profile in channel Z? So, we've heard a lot of this with dual share classes, generic example being a fund that is kind of entrenched in the retirement space with DC assets, they would benefit greatly from kind of an ETF share class because it would give them that inroad into kind of the advisory channel, right? And the premise is logical, but there's still kind of a breadth of information. beyond that decision. from a strategic planning and execution perspective of whether or not that would hold true. So we're gonna talk a bit more about kind of the fiduciary angle and how boards are gonna be tasked with protecting shareholder interests there, but that's gonna be a big part of kind of the decision, whether it's conversion or a dual share class adoption, one that boards are acutely aware of, so. Yeah, for sure. So we got the results of that first polling question out. As you can see, a lot of people find that their board is, you know, moderately or minimally prepared. Some are not prepared at all. very scant minority that would consider themselves well -prepared or fully ready to act. So quite a bit of education to do, a lot of conversations to be had before we feel confident that boards are ready to move on with the introduction of the ETF share class. I was thinking, Carolyn, of a more specific case. Maybe we'll take a moment to sort of walk through some of those considerations for a hypothetical here. Let's say we have mutual fund with a lot of unrealized capital gains. They have a pretty diversified, spread out retail investor base. What might be some of the decision points that we want to walk a board through in order to really get engaged with that ETF share class offering? I mean, I think it's an interesting issue. 

And I think when we first started talking about ETF share classes, I think everyone thought maybe an ETF conversion was kind of out of the question. I think everybody thought, oh, we'll just hang ETF share classes off of everything. And I think that's becoming increasingly clear that that's not going to be the case. And to Elizabeth's earlier point, having an ETF share class in this particular scenario is not a magic wand to get rid of the tax issues for these mutual fund investors. But I think what is going to happen practically here is management is going to come to a board with a proposal, whether it's an ETF share class, whether it's a conversion, whether it's, you know, a clone ETF potentially for the strategy. And then the board is going to sort through some of the questions. And I think what I would expect a board to start with is how do our current shareholders hold the shares? For example, you know, to Corey's point, are they all in, you know, a retirement plan? Do they hold them directly with the fund? Because that's going to make possibly a good case for an ETF share class, because that way, those shareholders can keep their funds, and hopefully, we can get some new shareholders in the fund by offering an ETF. Do they want to invest in an ETF? Are these shareholders really a group of investors who would prefer an ETF, but they're in this fund, and they they don't necessarily want to pay some extra capital gains on top of it. I think the other question is the exchange feature between the mutual fund share class and the ETF share class is going to be an operational concern that is not going to be ready to go on day one, even for those complexes that are really far ahead in planning for this. So how does that impact the decision ultimately to offer an ETF share class? I think another question a board is going to ask is, are these unrealized capital gains Is this an ongoing issue with the fund strategy? And I think that depends on, you know, and then the answer to that will depend on where you go from that. Oh, is it more efficient to have a total ETF structure? Because especially if you have a pretty large fund, you know, an ETF share class is going to be quite small in comparison. And is that going to, Elizabeth's point from earlier, you know, is that ETF share class going to be able to absorb, you know, some of these tax issues? And I'm not sure. that that's the case. 

I think the other question that boards are asking is, is this mutual fund viable? So even if we offer this ETF share class, is this mutual fund going to still be around? Can we still continue to offer this product? Because I think that's an important question to ask on the outset, because we want to know, are we hanging an ETF share class off a fund that's not really viable? And so a couple of years down the line, we're going to be making a different decision anyway. So I think that's important to understand. I think also we alluded to this a little bit earlier the distribution strategy. Is this going to disrupt the distribution of the mutual fund because the intermediaries are not going to want to have a lower cost option? So what is that going to do to the distribution? And are the intermediaries actually prepared to offer an ETF share class at all? So I think there's a lot of questions there to see if this is really going to be a viable option that's going to help this particular fund. Can the fee structure support an ETF share class? I think that's a question that boards are going to want to have really good understanding about before they approve a share class. And then finally, can the compliance department handle this? do you have the compliance department necessary? Because once you have some exemptive relief, that comes with it a lot of extra compliance burdens, plus all the other issues that you're going to have to address when you offer an ETF share class. So I think those are some really important considerations that boards are going to want to understand out of the gate before they proceed yes or no with a share class. Sure. I hope the audience has taken notes because this is really good stuff. In fact, I'd like to drill down a little bit into some of those operational difficulties. 

And Elizabeth, if we could turn it to you for a moment, what are some of those technological challenges that should understand when evaluating a manager's readiness to implement a dual share class structure? I mean, I think a lot of that depends on where the what I'll kind of call the infrastructure of the market in general lands. We're still waiting a lot of I think DTC has a has a path forward and the platforms will wait and act or not on, you know, sort of based on on where the dust settles there. But I think that the questions that board should be asking as it relates to technological readiness, operational readiness are basically the same as they should ask before blessing, you know, the establishment of ETS in general, but supercharged by the notion that this structure, which already, you know, sort of moves and is managed differently than a mutual fund to begin with, is then folded into and, you know, in some cases, maybe sort of bearing the inherited burdens of the mutual fund. So as kind of discussed at the top that the ETF, you know, it is traded in The ETF structure itself is traded in the secondary market. Somebody places a buy order on Schwab that gets affected through a broker, typically with a market maker on the other side. But the ETF as a portfolio is managed just like, you know, an SMA or a mutual fund, but with this additional outlet of the primary market process that create redeem process. So now when you have a, um, a structure that is it's a unified portfolio between these different types of share classes, but only part of the portfolio has that primary market mechanism available to it. You sort of have to hold fragmented view or be able to hold sort of not competing, but different types of rules for how you can manage the portfolio overall. 

So I think capital markets is an incredibly important element of ETFs. And I think, you know, certainly, managers have successfully stood up ETF operations without adding headcount. But to the extent now that your mutual fund depends on the know -how embedded within ETF capital markets, I think boards should be asking about that type of expertise in general. And then there are very practical considerations. A mutual fund manager typically doesn't have to be hyper aware of tax lot level data on the portfolio for management purposes. But in ETFs, lot level data is where all of the, what we call the tax alpha lives. And the average OMS that's suitable for trading a mutual fund or SMAs or what have you, just even now, 32 years into ETFs, the average OMS is not equipped to address ETFs, let alone ETFs that are kind of trying to drive this now combined structure. So I think basically, long story short, it will be, are your systems equipped to capitalize on the very essential components of ETF portfolio management? And do you have the expertise needed to kind of wield the partnership of the street for the benefit of the structure and thus of the shareholders. And I think those are going to be the two very important things. 

Gotcha. Yeah. There's a lot of details still to be sorted out. I want to direct the next one to Corey. I'm thinking about there's a presumption, and I think it's probably a fair one, that the very largest players are going to be the quickest to market with ETFs. They just have the resources and deep pockets. Now, let's say I'm with a smaller manager. How do I compete with those very large established ETFs? What sort of non -fee differentiators should a board look at when considering the ability to attract new assets? Yeah, it's an important question and a difficult one to answer. Yeah, you take, you take that starting point as that small manager and whether it's a dual share class or a conversion. And there's certainly the headwinds of the operational readiness and infrastructure that you certainly need to be prepared to handle. I think I would say that you're probably need to take a more kind of detailed approach on that. who that investor profile that you're really trying to seek out there is. So specific channels, advisory channel, how do you, what is the path there, acknowledging the fact that from a fee competitiveness that you certainly just, you're gonna be at a disadvantage of competing with those much larger players, but you really need to kind of be thoughtful with your intermediaries, with your partners to really establish a path forward to success in those channels and really kind of find your niche within a distribution dynamic.