Vanguard’s ETF Patent Expires: A Game Changer for the Investment Industry

This patent allowed Vanguard shareholders to save quite a bit of tax over the years and helped solidify its dominance in ETFs sector.

But that sheer dominance may be coming to an end. Thanks to the patent expiring, many companies have started to step in and plan similar ones ETFs share classes of their funds. The ultimate winner will be investors who can now save on capital gains taxes.

Exchange-traded funds have exploded in popularity for a variety of reasons. But one of the biggest may be their tax efficiency. This comes from their structures. ETFs work because of their dual nature.

You and I buy ETFs in the secondary market. However, authorized participants – institutional investors, endowments and investment banks – can buy ETFs in the primary market. Here they exchange cash or enough securities to “make” a share of ETFs. Put simply, it works like this: instead of holding all the stocks in the S&P 500, an institutional investor calls State Street, hands them the stock, and State Street gives them newly minted shares at SPDR S&P 500 ETFs Trust.

The reason why ETFs outperform mutual funds is the reverse of this process. Whatever sale happens in a mutual fund—whether it’s investors buying money or a manager booking profits—mutual funds pay out those capital gains, and investors pay the taxes. Because of the primary market, when an authorized participant wants to exit the fund, he can receive payment in kind with all the shares of the underlying units. The same goes for active management and a manager looking to sell a position. They can actually transfer the shares.

This is where Vanguard comes in.

Vanguard developed a patent in 2001 that allowed them to classify their ETFs as a class of shares of their mutual funds. This was fortunate because it allows Vanguard mutual funds to rely on ETFs to improve tax efficiency. For example, on Vanguard 500 Index Fund has not paid a single capital gain since 2001, when the patent was created, because its managers can use the ETF’s authorized participants to obtain the shares.

This gave Vanguard a huge asset-raising advantage, lowering costs for investors and helping it dominate ETFs league tables.

All good things must come to an end. For Vanguard, the end of the patent came in the spring. This patent expired in May of this year. And it looks like several heavyweights have started looking for relief after the leak and starting their own ETFs share classes of their mutual funds.

Most interestingly, these documents are for active mutual funds.

First up was Australia’s Perpetual. Then this summer Dimensional Fund’s heavyweight advisors (DFA), filed in SEC to begin using the expired patent in its mutual funds. DFA has already made a splash in the world of active ETFs by using a mutual fund to-ETFs conversions. These moves quickly made him one of the biggest players in the industry. For DFAthe addition of an ETFs share class would help to limit the potential “squeezing” of assets out of its funds. Originally sold only through a series of exclusive financial advisers, many of its funds include many long-term shareholders who are now entering their golden years.

Most recently, investment giant Fidelity, which oversees more than $4.3 trillion in assets, filed to offer ETFs share classes of its active mutual funds. In its October 24, 2023 filing, Fidelity said it was doing this to “help meet the changing needs of investors” and “for those investors who prefer to invest in ETFs and are interested in existing funds, ETFs The class could be an attractive investment opportunity.” If it gets an exemption, Fidelity could instantly become one of the biggest ETFs managers of the planet.

Now analysts speculate that other big managers will have to step in and take advantage. BlackRock, JP Morgan and heavyweight mutual fund managers like Franklin Templeton may be next in line to file their own ETFs share classes.

Before investors get too excited, there are some caveats and potential hiccups in the works. On the one hand, SEC has not budged at all on these documents. Vanguard’s patent was for use with index ETFs. In general, these market-tracking funds don’t necessarily generate that much capital gain in the first place. Active funds may be a different story.

This brings us to the second part: the tax efficiency of ETFs and their ability to transfer securities to avoid paying capital gains tax is already in Washington’s crosshairs. Back in 2021, Senate Finance Committee Chairman Ron Wyden wrote legislation that would create an ETF tax to cover “phantom” capital gains and authorized participant creation/repurchases. Legislation has gone nowhere in recent years. But if active funds and more investment managers start using the patent, we could see the US Treasury begin to miss out on enough revenue to tip Washington’s hand.

Second, many mutual fund managers close active funds if they become too large and cannot meet their mandates. The SEC there are no such rules for ETFs. This can be a problem if a fund has ETFs share class.

Finally, a mutual fund share class can potentially harm the tax efficiency of ETFs if its capital gains are too great to be redeemed in kind. ETFs capital gains are very rare, but they do happen. And they could happen more with active funds and companies using the patent.

With Vanguard’s patent expiring right now, we’re in the early days of companies starting to use the structure. The odds are in favor of those firms that offer index funds to move in first. Firms like Fidelity, BlackRock and T. Rowe Price could quickly and easily adopt the structure for these funds.

As for activity, the outlook is a bit murky. The SEC there is a complete list especially with all bitcoins ETFs drama. It may be a long time before we see ETFs share classes of active mutual funds. And even then, Washington gets to have its say on taxes. This can hinder the whole process.

Either way, active ETFs are quickly becoming the preferred funding structure for many asset managers and investors. With mutual fund-ETFs conversions, new launches or ETF copying of existing mutual fund strategies, the active ETFs boom is on. Vanguard’s patent expiration could be the next step for companies looking to launch products and gain assets.

Vanguard’s patent allows the use of ETFs as a share class for its mutual funds. And now, with the expiration of that patent, many companies, from Fidelity to DFA, try to use it for active strategies. This could be a game changer for the industry, although there are some hurdles to overcome first.