With the confirmation of Paul Atkins as chair of the Securities and Exchange Commission, momentum is growing for a resolution to the outstanding exchange-traded fund applications from asset managers. More than 50 managers have requested exemptive relief to offer dual share classes of traditional mutual funds and ETFs.
But there is one central concern that has yet to be addressed that does not even have a clear definition from the regulator: Cross-subsidization.
This can loosely be described as investors in one share class subsidizing or supporting another share class, in this case ETFs and mutual funds. If a manager were able to offer dual share classes of mutual funds and ETFs then there is a chance that one of the two classes would end up being paid for by fees from the other.
The SEC has disapproved of cross-subsidization in the past, but it has yet to define the meaning in the mutual fund context. This has caused problems for the industry, but managers have been developing workarounds. Cross-subsidization was first mentioned in Rule 18F-3 on arbitrage funds that simply stated: “The Board of Trustees will monitor any such waivers or reimbursements to ensure that they do not generate inappropriate cross-subsidization between classes.”
In its 2019 rule that modernized the regulation of ETFs, the SEC again referenced the idea but still failed to define it, only outlining potential ways in which funds could address the issue, such as transaction fees. In the final rule, the SEC said the issue would arise if a class is incurring expenses that it would not otherwise have — even if an investor is paying the same fee, according to Stacy Fuller, partner at K&L Gates. (Expenses are deducted directly from a fund’s assets.)
“I think that’s been a problem for many years, because until you know what cross subsidization is — which we still don’t — it’s hard to address it in an exemptive application context or any other,” she said, speaking during a webinar on the topic last week. “The way it’s interpreted here is really the same as what mutual funds do: All the classes come together to impose different costs on the fund. What makes it a mutualized structure is that the different classes share those expenses.”
As a result, Fuller is not sure what cross subsidization specifically is, but she suggested that the SEC staff do have a clear idea and that the Commission seems poised to treat it principally as a conflict of interest that needs to be resolved and overseen by the board.
Despite the ambiguity, fund managers are taking steps to manage the situation, as the numerous outstanding applications would suggest. These will be reviewed by the regulator and a new standard may potentially surface after the evaluations are done. Sources say the industry has made progress on resolving operational challenges that need to be addressed before launching dual share class structures.
Dimensional Fund Advisors’ application is expected to be something of a template for others seeking similar exemptions on the existing rules. The firm recently amended its previous application based on SEC feedback.
In the DFA application, which has the SEC staff’s support, cross-subsidization is not eliminated altogether but overseen by the board. This requires the advisor to conduct a qualitative assessment of the funds and do a cost benefit analysis for the board up front establishing that they are appropriate candidates for the structure.
Advisors would then need to do ongoing monitoring and collect data for the board, which would annually evaluate the analysis and determine whether remedial actions are needed.
“It feels very much like a derivatives risk management program, because it contemplates setting parameters that the advisor believes would indicate the program was successful, monitoring, escalating and tweaking as necessary,” said Fuller.
For now the SEC seems content to review applications individually but this may change with actual rulemaking in the future, especially as the number of applications continues to rise.
Amrita Nandakumar, president of Vident Asset Management, said that it is not surprising that the pro-innovation Atkins-led SEC may be more open to approving ETF share classes of mutual funds than the previous SEC regime, and in a timelier manner than the industry was anticipating.
“Whether these multi-share class structures are approved this month or this year, issuers seem to be underestimating the operational lift that will be required to accommodate these new share classes,” she said. “Any mutual fund manager that has ever launched an ETF is aware of how operationally complex the transition can be, and I anticipate that the dialogue will soon evolve into how issuers and ETF service providers are transforming their operational capabilities to support multi-share class ETFs.”
