Canada’s success in launching ETF share classes could pave the way for more of these offerings in the U.S. and beyond, according to a report from National Bank Capital Markets.
Released earlier this month, the report explores the pros and cons of ETF share classes, more commonly known as ETF series in Canada, in anticipation of further approvals of the products in the U.S. It also provides a snapshot of the existence of these funds in various jurisdictions.
In essence, an ETF series is an additional series of a mutual fund, but it’s allowed to trade on an exchange like an ETF. For mutual fund providers, the product structure offers an accessible pathway into the booming ETF market.
“Compared to standalone ETF ‘clones’ of mutual funds, the ETF share class model delivers scale, efficiency and inherited performance history,” the report says.
“While full conversions maximize tax benefits, adding an ETF share class provides a lower-risk entry into the ETF space.”
Canada vs. U.S.
The report identifies Canada as a leader in bringing these offerings to market — providing a blueprint for other markets to adopt the dual-share class structure.
“Canada stands out among developed markets for its fertile ground for the proliferation of ETF share classes of mutual funds,” it explains.
“The country’s uniquely friendly regulatory environment around ETF series supported the growth of this structure, especially compared with the U.S.”
Introduced to the country in 2013, the product structure is “widely adopted” in Canada, with 346 ETF series offered across 25 providers as of September, the report notes. They’ve also doubled in number and quadrupled in assets since 2020, outpacing standalone ETFs.
Contrary to popular belief, the report stresses that ETF series “typically experience net inflows into their mutual fund series, indicating that the multi-class structures do not necessarily hinder overall asset growth” of mutual funds.
This is one of the reasons National Bank Capital Markets expects the product structure to take off elsewhere.
“Canada’s success — and the apparent absence of self-cannibalization — may inspire U.S. issuers, especially as regulatory changes pave the way for more ETF share class launches,” it says.
South of the border, the U.S. Securities and Exchange Commission (SEC) allowed Vanguard to create the product structure under a patent that lasted from 2001 until 2023.
Since the patent expired, more than 80 firms in the U.S. have filed applications with the SEC to copy the structure or convert their mutual funds to ETFs. And in late September, Dimensional Fund Advisors LP was the first asset manager to receive approval from the SEC to launch ETF share classes.
The landmark decision is expected to lead to broader adoption in the U.S., the report says, noting that the “80+ asset managers filing applications oversee over 75% of total mutual fund assets in the U.S.” It comes at a time when ETF assets in the U.S. are “growing at a phenomenal pace” while their mutual fund counterparts have been suffering sustained redemptions since 2018.
At the same time, with the gates being opened to more ETF share classes in the U.S., there are concerns that this will create increasing competition for fund providers in Canada who have benefited from the ability to offer these structures while providers in the U.S. with larger economies of scale — aside from Vanguard — were left out of the picture.
But in a recent interview with Investment Executive, Sal D’Angelo, head of marketing for Vanguard Canada and head of product for Vanguard Americas, said these concerns were “overblown” and that “there’s always going to be demand for Canadian solutions.”
“The patent expired a few years ago. There’s a ton of other ETF providers in the U.S. that were always accessible to Canadians,” D’Angelo said.
“I always use the example of our largest ETF in Canada, which is our S&P 500 ETF. Our U.S.-domiciled version of that is arguably more competitive in terms of fees, but despite that, our Canadian-domiciled ETF takes in more flows and is double the size relative to Canadians holding the U.S. version of it.”
ETF share classes are also available in other markets, including Europe and Australia.
The draws
The dual-share class structure has several draws.
For one, sharing the same operational infrastructure across different series of a fund allows fund companies to save on legal, audit, custody and administrative expenses.
In Canada, issuers can add ETF series via a prospectus document, whereas in the U.S., it’s a tad more complicated to introduce the multi-share class structure, “but then adding new ETF series should be simpler once systems are in place,” the report notes.
Another benefit of ETF share classes is that they’re able to leverage the larger assets under management of the existing mutual fund to lower per-unit fixed costs.
Also, since they’re tied to an existing mutual fund, they offer investors a longer track record for evaluating a fund’s performance rather than starting with a blank slate.
There are tax advantages south of the border, too. “In the U.S., ETF series’ tax efficiency using in-kind redemptions could benefit the mutual fund unitholders, since the mutual fund shares the same asset pool with the ETF,” the report says.
The drawbacks
The product structure also has some drawbacks, including cash drag, “cross-subsidization” and fee parity constraints, the report points out.
For instance, mutual funds hold a decent amount of cash to meet redemption requests, and their ETF series take after them. But if holding cash is not part of an ETF series’ intended strategy, it “cannot be as fully invested as a standalone ETF with the same mandate, which can dilute returns for ETF series holders,” the report notes.
Moreover, there may be unexpected tax consequences, as the realized taxable gains associated with redemptions from one series of a fund may be passed on to another.
“In the U.S., in-kind creations/redemptions for ETF series reduce this impact, but not always fully,” the report says.
“In Canada, given that ETF series are typically created/redeemed in cash, cross-subsidization can happen in either direction. However, capital loss carry-forwards are also shared between ETF and mutual fund series.”
There may also be cross-subsidization of transaction costs, the report notes. In other words, when investors exit or enter a mutual fund, there are costs associated with such transactions, which are “borne by the fund and thereby averaged across all unitholders” — including ETF series investors.
“These cash transactions on underlying securities could result in a moderate level of ‘shared transaction cost’ drag for all share classes, even if ETF units are created and redeemed in-kind,” the report says, while noting fund managers could attempt to minimize the trading costs by spreading trades over multiple days, allowing inflows and outflows to offset each other, or trading most liquid positions first.
Another drawback is that ETF series tend to have higher management fees than standalone ETFs, typically costing about the same as a mutual fund F series.
In the end, National Bank Capital Markets says it’s up to individual fund companies to weigh the pros and cons.