Expiry of Vanguard ETF patent could spark run of copycats

When Vanguard’s patented exchange traded fund structure expires in May it could open the floodgates for other asset managers to copy it, if the first filing to do so is approved.

The world’s second-largest asset manager currently has the exclusive right to use the “ETF-as-a-share-class” structure it patented in 2001. The unique design allows Vanguard to operate a mutual fund and a sister ETF as essentially the same vehicle, generating superior tax efficiency and economies of scale.

But the fate of the filing may go some way to determining whether other rival fund groups will be permitted to copy it.

“I know a lot of people are watching this with interest,” said Jeremy Senderowicz, a lawyer at Vedder Price who is focused on the investment industry. “If this [request] is granted I would expect that a number of applicants would apply for similar relief.”

The application has been filed by PGIA, the US arm of Australian asset manager Perpetual, which manages 20 mutual funds, with combined assets of around $10bn in the US under the brands of affiliates JO Hambro, Trillium, Barrow Hanley, Regnan and Thompson, Siegel & Walmsley.

Rob Kenyon, chief operating officer of PGIA, said, if granted, the filing for exemptive relief to adopt the Vanguard structure would apply to all its funds.

“We would assess each strategy based on its features and not every one might be a good fit,” Kenyon said.

“We believe that it can deliver benefits to investors and all stakeholders within the industry. It offers the ease of choice to investors, it avoids cost and complexity and delivers an efficient vehicle to offer a combination of a traditional mutual fund and the ETF share class to investors.

“What we propose is the same investment team, same strategy, same portfolio and same management fee.”

Vanguard currently operates 70 multi-share class funds with combined assets of $4.8tn, about 60 per cent of its total AUM. The fact that the SEC has allowed it to use the ETF-as-a-share class structure for both its pre-existing funds and some new funds does not, though, necessarily mean the financial regulator will permit others to adopt it after the expiry of the patent.

Since giving Vanguard the green light in 2001, the SEC appears to have got cold feet. In 2019 it raised concerns about potential conflicts of interest among investors in a fund’s share classes.

A mutual fund, for instance, must sell shares if it faces redemptions, incurring trading costs, but an ETF can instead hand a parcel of securities to an authorised participant, the market makers that act as middlemen for ETFs.

“An ETF share class that transacts with authorised participants on an in-kind basis and a mutual fund share class that transacts with shareholders on a cash basis may give rise to differing costs to the portfolio,” the SEC said in 2019.

“As a result, while certain of these costs may result from the features of one share class or another, all shareholders would generally bear these portfolio costs.”

The SEC declined to comment for this story.

Senderowicz said that while the SEC “does try and avoid an unlevel playing field, that doesn’t guarantee that that won’t be the outcome”.

There is precedent for just such a scenario, he added — the SEC granted exemptive relief to three fund sponsors to issue leveraged and inverse ETFs in 2006, “then they had qualms and issued a moratorium, and did not issue [relief to others] for at least a decade”.

As regards the ETF-as-a-share-class structure, Senderowicz said that “since Vanguard was granted [relief] around 20 years ago, the SEC has evolved towards a different view of how ETFs should be structured”.

“Generally speaking, it can be an institutional challenge to get the SEC to revisit an older structure when they have developed a new view,” Senderowicz added.

Kenyon said he was confident that PGIA had solved the cross-subsidisation issue.

“We have tried to establish a process on how we account for expenses on brokerage costs,” he said. “We are not subsidising one or the other. We can account for different share classes and expenses.”

One other factor may count against PGIA: the SEC only granted Vanguard the right to use the structure for passive funds. When it asked for permission to extend it to actively managed funds in 2015, the SEC rejected the request.

This might not be a deal-breaker, however. Vanguard asked to use the format for funds that, unlike its passive vehicles, do not offer full portfolio transparency. PGIA’s proposed funds would be fully transparent.

Kenyon believed adopting the Vanguard structure was preferable to converting a mutual fund into an ETF — as a number of managers have done — given the complexity and time-consuming nature of such a switch, and the fact that some existing investors might prefer to remain in a mutual fund.

Likewise creating an ETF clone of a mutual fund is also suboptimal, be argued given that many fund distributors only want one version, rendering the other unavailable.

Kenyon also raised the possibility that approval from the SEC “maybe opens the way for ETF providers to open mutual funds as a share class”, which may appeal to some investors given that ETFs cannot offer fractional trading and have to be held in a brokerage account.

PGIA expects to hear back from the SEC within 120 days. “We have had a very constructive dialogue and I think it’s possible [we will get approval],” he added.