As the expiry of Vanguard's unique patent on May 16th 2023 fades in the rear-view mirror, the ETF industry stands on the precipice of a transformative shift.
For more than two decades, Vanguard has held exclusive rights to structure ETFs as a distinct share class of their existing mutual funds—a mechanism that has set the company apart within the investment landscape, offering enhanced tax efficiencies and economies of scale.
With the expiration of this patent, the gates are set to open for other investment firms to adopt this once-proprietary structure, thereby potentially catalyzing significant changes in the dynamics of the ETF industry.
The impacts of this impending transition are expected to reverberate across various stakeholder groups: reshaping industry competition and innovation, influencing ETF investors' choices and costs, and possibly prompting regulatory and taxation reviews.
As the post-patent era begins, it becomes increasingly crucial to comprehend the potential transformations and strategize for the opportunities and challenges that lie ahead in the ever-evolving investment universe.
Let's take a deep dive into the multifaceted implications of this transition—exploring potential scenarios for the ETF industry, competitors, investors, and regulators.
Understanding Vanguard's patent
Readers interested in the patent in its entirety can find it linked here, but for your reading convenience I've summarized the main points below and provided some key analysis throughout.
Essentially, Vanguard's patent enabled it to offer both traditional mutual funds and ETFs as different share classes within the same fund. This structure has been referred to as the "hub-and-spoke" structure by some fund experts, or "ETF-as-a-share-class".
Traditionally, mutual funds and ETFs are separate entities, each with their own portfolios. Mutual funds allow investors to buy and sell shares at the end-of-day net asset value (NAV), while ETFs trade on an exchange like stocks, allowing investors to buy and sell shares throughout the day at market prices.
However, Vanguard's patented structure took a different approach. It established a mutual fund (the "hub") with multiple share classes (the "spokes"), which includes ETFs. The mutual fund itself is like any other, with shares bought and sold at the end-of-day NAV.
The spokes, however, are classes of shares that can be ETFs, which trade on exchanges. Because they're part of the same fund, the ETF and mutual fund shares hold identical portfolios.
As an example, consider the Vanguard Total Stock Market ETF (VTI). On Vanguard's website, you'll see a link that says, "Also available as an Admiral™ Shares mutual fund". That fund is the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX).
In the case of VTI, you can actually scroll down to the "Portfolio composition" section and look at the metric "Share class total net assets", which currently stands at $285.5 billion. That is the assets under management, or AUM that just VTI, the ETF possesses.
Above is the metric " Fund total net assets", which stands at $1.3 trillion. This is the AUM possessed by all the different share classes within the overall fund, whether from ETFs or mutual funds.
One of the key benefits of this patent is improved tax efficiency. Typically, when mutual fund investors redeem their shares, the fund may need to sell securities to raise cash for the redemption, potentially triggering capital gains.
In contrast, ETF shares are usually redeemed "in-kind", meaning the ETF transfers securities to the redeeming investor rather than selling them for cash, which doesn't trigger a taxable event.
Because the Vanguard structure allows the mutual fund and ETF to share a portfolio, it can use the "in-kind" redemption process for both types of shares, reducing the likelihood of triggering capital gains. This has made Vanguard's mutual funds more tax-efficient.
Effects of the Vanguard ETF patent expiration
“The widespread availability of a multiple share class mutual fund/ETF structure would mark a critical shift, driving growth across the asset management industry for the benefit of investors, advisors and money managers. Our ETF team at the NYSE has been working closely with asset managers looking to file with the SEC to obtain approval to utilize a multiple share class structure, and we encourage other asset managers to follow suit. While we continue to see a record number of new asset managers launching their first ETF each year, having an industry-approved multiple share class structure can drive even more growth for ETFs,” said Douglas Yones, Head of Exchange Traded Products at the NYSE.
The expiry of Vanguard's ETF patent could lead to a significant shift in the ETF industry. Some of the general trends I envision developing include:
- More innovation: No longer blocked from issuing ETFs as a share class of their mutual funds, fund managers may be motivated to experiment with new offerings. We might see more diverse and innovative ETF products coming to market, as companies aim to differentiate themselves, as long as regulators permit it.
- Increased competition: As other companies like Fidelity, Schwab, BlackRock (NYSE:BLK), and State Street (NYSE:STT) likely move to adopt Vanguard's structure (again, should regulators be permissive), competition could increase. This could push firms to continuously improve their products and services and to find new ways to attract and retain customers.
- Changed dynamics: With Vanguard's patent now expired, some firms may hold off on the recent trend of converting mutual funds to ETFs, and instead wait for the ability to issue new share classes via the ETF structure.
Beyond the broad ETF industry, I think its also worth analyzing the effects on key ETF stakeholders, which I define as competitors, investors, and regulators:
Competitors:
- Competitive pressure: Companies may feel the need to adapt quickly to avoid being left behind. This could include not only adopting the ETF share class structure but also improving other areas of their business to compete more effectively with Vanguard.
- Potential acquisitions: Smaller boutique ETF firms that are struggling to compete could become acquisition targets for larger firms able to leverage their size for economies of scale. This could lead to further consolidations in the industry.
Investors:
- More choices: Investors could benefit from having more ETF options, potentially leading to better diversification opportunities. Increased competition could also push firms to lower their fees, potentially reducing costs for investors.
- Education needs: With more choices and potentially more complex products on the market, investors might need to educate themselves more on the different offerings and their implications.
Regulators:
- New regulatory challenges: With the patent's expiry, regulators will need to grapple with the implications of allowing other firms to utilize Vanguard's structure, balancing the need for competition against fairness for different types of shareholders.
- Taxation review: The tax-efficient structure of Vanguard's ETFs might become widespread, which could lead to changes in how these products are taxed. This might necessitate a review of tax laws relating to ETFs.
This content was originally published by our partners at ETF Central.