The SEC's Two Masters

Understanding the fight over ETF share class filings for mutual funds

The biggest story in asset management is happening right now, and no one is talking about it. I’ll try my best to unpack it here.

But first, in order to understand it, you have to understand how taxes work inside these funds. So bear with me while we nerd out for a bit.

Mutual Funds buy and sell stocks for the fund. In addition to trading and rebalancing, when people redeem their fund shares, portfolio managers have to sell stock. This creates realized taxable gains and losses.

So, let’s say your Uncle Irving and Aunt Edna have been making monthly contributions to the Growth Fund of America since 1975. Well, let’s say the fund portfolio manager used their money in 1975 to buy a share of Exxon Mobile at an adjusted present value price of $2. That share of stock remains on the books today, and the current value of that share is $120. Cheers to Irving and Edna!

Also on the books for that mutual fund is an $118 unrealized capital gain on that share of stock. Along with a whole bunch of other shares that have been bought over the years for all of their clients.

As it turns out, the amount of unrealized capital gains on the books at mutual funds is astronomical. According to ICI, mutual fund AUM is currently $26.38 Trillion. I went through the annual reports of several of the oldest seasoned mutual funds and found that the amount of net unrealized capital gains on the books was 46%.

Let’s conservatively mark that down to 40% to account for newer funds. That gets us to 12.1 Trillion in unrealized capital gains exposure. To put that in context, the entire US tax collection revenue last year was under $5 Trillion. That’s more than the combined GDP of Japan and Germany. And so on: it is a lot of money.

And I need to add here the real kicker: these capital gains are realized through stock selling, primarily through fund redemptions. But it is not the person who redeems the fund that gets hit with them, oh no, the first one to grab the lifeboat escapes unharmed. For reasons that make no sense to anyone, the capital gains are distributed to the remaining shareholders.

Ok, I’m still setting the groundwork here. Let’s now talk about ETFs. ETFs have this little tiny nuance that’s wreaked havoc on the fund space. Back in 1997 the IRS issued a Private Letter Ruling that allowed ETFs new share creation or redemption to be considered in-kind.

What this means in English is that changing a share of an ETF with the proportional shares of the stocks that make up that ETF is not a trade that should be considered a taxable event by the IRS.

Ok, all of this makes sense and is harmless. Except, what it allows the ETF issuer to do is to select the individual shares held by the ETF to be sent out in a fund redemption.

So when Irving and Edna redeem their mutual fund shares, the portfolio manager sells Exxon and creates a $118 capital gain for the remaining shareholders. But when Irving and Edna redeem their ETF shares, the ETF simply hands the $2 cost-basis share to the market maker and calls it even.

And thus has been the state of the asset management space, where ETFs have slowly and steadily been feasting on mutual fund assets:

what do you mean by bloodbath?

Except for this one thing. Except for Vanguard.

Back in 2001 some really smart people at Vanguard did a really smart thing. They figured out that the ETF in-kind mechanism could be used to clean out the cost basis of not only the ETF assets, but the mutual fund assets too.

One pool of assets, one custodial account, the ETF mechanism continuously cleaning the shares, and both the mutual fund and ETF investors drinking from the same drink.

mmm tastes like ETF

Being all about saving tax liability for their own clients, but fuck ‘em if they don’t invest with us, Vanguard patented the methodology and licensed it to none of the fund companies who asked. From a competitive standpoint, it was brilliant.

And now, alas, the Vanguard share class patent has expired.

Now somewhere in the haziness of ambiguous rules, in the rumor mill of “the SEC likes this or doesn’t like that” has emerged the talking point that the SEC will not approve ETF share class filings for existing mutual funds.

And while that may be unfair, it certainly isn’t without reason.

You can’t serve two masters, and the SEC can’t simultaneously serve the interest of the tax-avoiding investor and the interest of the government that funds them. $12 Trillion in unrealized capital gains ain’t chump change. Hell, the SEC’s entire budget is $2 Billion, and we’re talking about eliminating 12T in taxable gains? That’s gonna be a tough sell in DC.

And this is the story, the biggest story in asset management that no one is talking about.

Which brings us to the latest development, a brilliant move by the Cboe exchange, who filed with the SEC’s division of Trading and Markets for permission to list funds with this structure. This follows Morgan Stanley, DFA and Fidelity filing down the hall with the SEC’s division of Investment Management. The industry is fighting to level the playing field.

If this goes through, the winners will be mutual fund investors and the ETF capital markets ecosystem: market makers, exchanges, service providers. This group of winners will no doubt include your humble narrator.

The loser will be the IRS.

The winner is Uncle Irving, the loser is Uncle Sam.

And no less than 12 Trillion in cap gains hang in the balance.