(Article from Registered Funds Regulatory Update, April 2023)
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On February 7, 2023, Perpetual US Services, LLC, doing business as PGIA, a registered investment adviser, filed an exemptive application primarily seeking relief to permit the creation and operation of an actively managed ETF share class of an open-end fund that is not exchange traded. Rule 6c-11 under the Investment Company Act, adopted in 2019 to establish a consistent regulatory framework for ETFs, does not permit a fund with such a structure to rely on the Rule.
Proposed Exemptive Relief
Historical Precedent. This application leverages off of a substantially similar SEC order granted to Vanguard Index Funds in October 2000 for an index-tracking fund, except here relief is also being sought to create an ETF share class of an actively managed fund. Notably, Vanguard holds a patent on this ETF-as-a-share class structure, which is due to expire later this year. If adopted, the fund’s board would be permitted to authorize the issuance of an ETF share class following a determination that the expense allocation among any open-end fund class and ETF class is in the best interests of each class individually and of the fund as a whole.
Conversion Privilege. Similar to Vanguard’s multiclass structure, PGIA would offer certain holders of fund shares the opportunity to convert such shares into ETF shares of equivalent value (“conversion privilege”) with the goal of moving investors who currently hold open-end fund share classes into ETF share classes in an expeditious and tax efficient manner. Solely at the option of the shareholder, this conversion privilege would only permit holders of open-end fund share classes to convert those shares into an ETF share class at NAV, and not vice versa.
Policy Considerations
PGIA submits that this exemptive relief is both necessary and in the public interest because ETFs provide investors with a number of important features, including intra-day liquidity, tax efficiency, and relatively low transfer agency and distribution-related costs. Without this exemptive relief, PGIA argues the existing alternative of reorganizing a mutual fund into an ETF leaves mutual fund investors with only one option, choosing between mutual fund shares or ETF shares. By offering investors a choice in both mutual fund and ETF share classes, their assets would pool into a singular vehicle, thereby enhancing the long-term viability of each share class. The SEC
has previously expressed general concerns to expanding this type of exemptive relief to other sponsors and funds, believing the following various policy considerations could be prohibitive to approval:
Share Class Subjugation. Section 18(f)(1) of the Investment Company Act provides that it is unlawful for any registered open-end investment company to issue any class of senior security or to sell any senior security of which it is the issuer. PGIA argues that neither share class would be senior to the other since both would have equal voting rights, and the proposed exemption is consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Investment Company Act.
Cost Subsidization. When it declined to include an ETF share class of a mutual fund in Rule 6c-11, the SEC flagged the issue of potential cost subsidization between ETF and traditional mutual fund share classes, such as unequal brokerage and other costs associated with buying and selling portfolio securities in response to inflows and outflows. Under PGIA’s proposal, all brokerage expenses are expected to be automatically allocated on a daily basis and fed into the strike of the daily NAV for each share class, obviating brokerage cost or expense subsidization concerns.
Tax Implications. Potential distributable capital gains and “tax contagion” issues may arise if the outflows in mutual fund share classes produce more realized capital gains that can be offset and, consequently, the ETF share class owners may need to absorb their pro rata share of taxable capital gains. However, PGIA argues that since the redeeming shareholder receives a step-up basis on the ETF class assets received in kind, any federal income tax consequences could be mitigated by having the ETF class shares distribute those securities with the highest built up capital gains, while the mutual fund would convert to cash those securities with the least capital gains. Additionally, PGIA can also employ methods, such as equalization accounting to adjust for any negative tax consequences on an annual basis.
Cash Drag. In 2019, the SEC also voiced concerns associated with cash drag on performance originating from holding the necessary cash amount to satisfy mutual fund share class redemptions. Since mutual funds often hold cash positions in the range of 1-3%, PGIA does not expect cash drag to materialize from the need to meet potential redemptions stemming from the ETF share class.
Operating Expenses. PGIA expects that contractually committed caps on total operating expense ratios would minimize or nullify any potential dislocation in ongoing operating expenses caused by uneven asset bases amongst the mutual fund and ETF share classes.
Conclusion
Despite the similarity of the requested relief to Vanguard’s existing fund structure, the SEC is expected to negotiate actively on the final terms of any new relief. Notably, the SEC declined to extend Vanguard’s requested
relief to actively managed ETFs in 2015. In the current political and regulatory environment, the timeline of such negotiations or their ultimate outcome is uncertain.
In the Matter of Perpetual US Services, LLC d/b/a PGIA, Application for an order under Section 6(c) of the Investment Company Act, for an exemption from Sections 2(a)(32), 5(a)(1), 18(f)(1), 18(i), 22(d) and 22(e) of the Investment Company Act and Rule 22c-1 under the Investment Company Act and under Sections 6(c) and 17(b) of the Investment Company Act for an exemption from Sections 17(a)(1) and 17(a)(2) under the Investment Company Act (Feb. 7, 2023), available at: http://edgar.secdatabase.com/2314/121390023009034/filing-main.htm.