Regulatory History and Policy Evolution

The concept of an ETF share class – a mutual fund offering both traditional shares and exchange-traded shares – has existed in limited form for over two decades. In 2000, the SEC granted Vanguard a unique exemptive order allowing certain index mutual funds to add an ETF share class, which the firm patented. This exclusivity was reinforced when the SEC adopted the ETF Rule (Rule 6c-11) in 2019. Notably, the 2019 rule explicitly excluded ETF share classes from its scope, citing distinct policy concerns. Rather than address these concerns in a broad rule, the SEC stated it would consider ETF share class structures on a case-by-case basis via exemptive applications.

In the years since, Vanguard’s patent expired in May 2023, and industry interest in multi-class ETFs has surged. By mid-2025, over 60 asset managers had filed applications seeking relief to add ETF share classes to new or existing funds. To date, none have been granted, but SEC officials have signaled a receptive stance. Over time, the SEC’s policy has evolved from wariness to an openness to permit ETF share classes, provided that certain investor protection concerns – chiefly the fair allocation of costs – are addressed.

 

Cross-Subsidization Concerns and Mitigating Measures

Cross-subsidization is the core policy issue that has long made regulators wary of ETF share classes. This term refers to one set of shareholders bearing costs or risks that stem from the activities of another set of shareholders.

In a multi-class fund where one class is an ETF and another is a traditional mutual fund, the potential for cross-subsidization is clear. Mutual fund investors transact directly with the fund in cash, causing the portfolio manager to buy or sell securities and maintain cash buffers for redemptions. ETF investors, by contrast, transact in-kind (through creations and redemptions with Authorized Participants) and typically do not require the fund to liquidate holdings for cash redemptions. Ensuring a fair allocation of such costs and benefits is crucial.

Current ETF share class applications tackle this issue head-on. Applicants uniformly pledge compliance with Investment Company Act Rule 18f-3, the rule that governs multiple share classes of funds. Rule 18f-3 requires, among other things, that each class has equitable rights and obligations and that no class is unduly advantaged at the expense of another (except for differences in permitted distribution or service fees). To meet these standards in the ETF context, fund sponsors are proposing robust safeguards.

For example, before launching an ETF share class, a fund’s board of directors (including independent directors) must affirm that the multi-class structure is in the best interests of each class individually and the fund as a whole. Boards will require detailed analysis from the adviser demonstrating that the expected benefits (e.g., greater tax efficiency, economies of scale, enhanced liquidity) outweigh any potential costs for both the ETF and mutual fund shareholders.

Boards will further expect to receive periodic reports comparing key metrics – cash drag, trading costs, realized capital gains, and other indicators – between the ETF and mutual fund portions of the fund. This is analogous to the structured programs now required for fund derivatives risk under Rule 18f-4: a formal plan, board oversight, defined risk metrics, and escalation procedures.

The intent is to ensure that any emerging imbalance – say, the ETF class consistently benefiting from in-kind redemptions at the expense of the mutual class, or vice versa – is detected early and corrected, or the share class structure revisited.

 

Operational and Infrastructure Challenges

Launching and operating an ETF share class will not be as simple as flipping a switch – it presents operational complexities that funds, intermediaries, and service providers must overcome.

Foremost is the need to integrate the ETF’s mechanics (exchange trading, in-kind creations/redemptions, real-time market pricing) into the traditional mutual fund infrastructure (daily NAV strikes, cash subscriptions/redemptions, transfer agent recordkeeping). In practical terms, a fund’s back-office and service partners must be capable of handling two very different transaction processes simultaneously within one fund.

For example, the fund’s custodian and fund accountant will need procedures to process creation/redemption baskets for the ETF class each day (often via the NSCC and DTC systems used by ETFs) while still settling cash flows and calculating income and capital gains for the mutual fund class. The transfer agent must coordinate with Authorized Participants to create or redeem shares in large blocks (Creation Units) for the ETF class, even though retail mutual fund shareholders may still interact with the TA for purchases and redemptions at NAV and in smaller share amounts. Ensuring that systems can properly allocate securities and costs to the correct share class in these processes is vital.

An exchange listing and market mechanics pose additional requirements. An ETF share class needs a listing on a national securities exchange, a designated ticker symbol, and typically a lead market maker to foster liquidity. The fund’s sponsor will have to work with an exchange to list the new class and comply with any listing standards. This includes disseminating indicative intra-day values (iNAVs) and daily portfolio holdings, as required under Rule 6c-11. For sponsors new to ETFs, developing this market-facing infrastructure is non-trivial – it demands expertise in capital markets operations that may not exist in a pure mutual fund shop.

A particularly thorny operational issue is facilitating share class conversions or exchanges for investors. One touted benefit of the multi-class approach is that an existing shareholder in a mutual fund could convert to the ETF class of the same fund (and vice versa, in theory) without selling the holdings – avoiding a taxable event.

The anticipated exemptive relief is expected to allow at least one-way conversions (mutual fund to ETF) via an “exchange privilege”. However, executing this seamlessly is challenging. Broker-dealers and custodians must develop processes to support direct conversions on behalf of clients. Currently, if a client holds mutual fund shares and wants the ETF class, the broker will typically have to redeem the mutual fund shares (at NAV) and separately purchase ETF shares on the market – a potentially taxable sale and repurchase.

Under the new structure, the goal is a non-taxable share class exchange, where the fund simply re-designates the shares from one class to another. Developing this “plumbing” is proving complex. Until these processes are ironed out, conversions may occur slowly or in a manual, case-by-case fashion. Sponsors have noted that operational preparations for conversions “may take time to develop” but are essential to realize the full investor benefits of ETF share classes.

The timeline and sequencing of industry adoption may be influenced by these operational hurdles. Even if the SEC grants relief in 2025, many fund sponsors might need additional months (or longer) to resolve integration issues with their transfer agents, exchanges, and brokers.

We may see a staggered rollout: the first adopters likely being firms that have invested in ETF capabilities or that partner with experienced ETF service providers, and smaller or less resourced sponsors following only after industry conventions for conversions and operations are established. The bottom line is that ETF share classes, while promising in theory, require substantial behind-the-scenes buildout.

 

Market Capacity and Liquidity Considerations

The introduction of potentially dozens of new ETF share classes also raises market-driven considerations, particularly regarding liquidity providers and the capacity of the ETF ecosystem. Each new ETF class will need seed capital and ongoing market-making support to trade efficiently. In a typical ETF launch, an Authorized Participant (AP) or market maker provides initial seed capital – often $2.5 million in assets or more – in exchange for creation units of the ETF, which then begin trading on the exchange. In the early days of ETFs, it was common for a single AP or lead market maker (LMM) to seed a new fund and hold a large percentage of the shares until a market developed.

However, after the 2008 financial crisis and ensuing regulations, APs and LMMs have grown more reluctant to tie up capital in seeding new products. Experience has shown that if an ETF fails to attract investors, the LMM could be stuck holding the position for months, bearing risk and capital charges. As a result, the industry practice has shifted – sponsors are often expected to “bring their own assets” or line up multiple seed investors to launch a fund.

Applying this to ETF share classes: Fund sponsors will need to procure seed activity for each ETF class they roll out. The good news is that many of these ETF classes will be tied to existing funds that may have substantial assets. That inherently provides some scale and may encourage market makers to participate, since an existing underlying portfolio can support or subsidize a new share class.

Nonetheless, if 60 fund complexes each try to launch multiple ETF classes in a short window, the demand on AP and LMM balance sheets, which are finite, could be heavy. They may triage which launches to support, favoring those from the biggest sponsors or most popular strategies. Smaller fund sponsors could find it challenging to secure enthusiastic market makers, potentially delaying their share class launches or resulting in wider bid-ask spreads initially.

Market maker support over the longer term is equally vital. An ETF share class will only succeed if it trades with reasonable liquidity and tight spreads, so that investors feel comfortable transacting in it. Here, too, having a sizable mutual fund with an existing asset base is beneficial – it likely means the portfolio is seasoned and may hold liquid securities that market makers can readily arbitrage. That tends to result in tighter spreads. However, some active strategies (e.g. those holding less liquid fixed-income, small-cap stocks, or thinly traded international securities) might present challenges: market makers will be cautious in quoting prices if they cannot easily hedge or if the fund’s basket composition is complex. Moreover, because these ETF share classes will operate within the constraints of a single portfolio shared with a mutual fund, there could be capacity constraints in the portfolio itself.

For example, if the fund strategy has limited capacity (perhaps it trades in niche markets), adding an ETF channel that brings in additional flow could pressure the strategy’s liquidity. This means portfolio managers need to be confident they can accommodate potentially faster in-and-out flows from ETF investors without harming performance for everyone.

Lastly, seed capital providers and market makers will evaluate the revenue opportunity of these products. Unlike launching a brand-new ETF with uncertain prospects, an ETF share class of a large, existing fund might be attractive – the fund already has assets and track record, meaning the ETF class could ramp up trading volume quickly as investors migrate to it. On the other hand, some ETF share classes might primarily serve to stem outflows (from the mutual fund) rather than bring in new money, such that trading volumes are modest. Market makers make money from the bid-ask spread; if volumes are low, their incentive to deploy resources is lower. Given fund sponsors cannot pay these partners directly like they can in other markets, they may need to engage with these players in a creative manner, possibly providing incentives (such as flexible custom basket policies, or waiving AP related fees) to ensure liquidity support.

In summary, while no insurmountable “capacity” issues are expected – the ETF ecosystem is large and dynamic – the convergence of so many traditional funds into the ETF marketplace in a short span is unprecedented. Sponsors and their counsel should proactively talk with partners to coordinate seeding and market-making plans for ETF share class launches. Properly handled, a well-capitalized ETF class with a strong arbitrage mechanism will benefit all shareholders through tighter spreads and efficient pricing. But poor planning could lead to tepid liquidity, wider spreads, and frustrated investors and partners. Early industry experience (e.g. the first few multi-class ETFs) will be especially instructive and may set the tone for broader adoption.

 

Distribution and Compliance Implications (Reg BI and Fiduciary Duty)

Introducing ETF share classes into traditionally broker-sold mutual fund lineups raises important compliance questions for distributors. Broker-dealers and investment advisors will need to navigate how to recommend or utilize these new share classes consistent with their regulatory duties – in particular, Regulation Best Interest (Reg BI) for brokers and fiduciary duty standards for advisors. Both regimes place a strong emphasis on choosing investments (or share classes) that are in the client’s best interest, taking into account cost and other relevant factors. The coexistence of an ETF share class and a mutual fund share class of the same fund will put a spotlight on share class selection practices that were already under scrutiny in recent years.

From a Reg BI perspective, brokers must not put their own compensation interests ahead of the client’s interest in obtaining a favorable investment outcome. Historically, mutual funds have often paid brokers via sales loads or trailing 12b-1 fees, whereas ETFs generally do not. This is evidenced by the rise of fee-based accounts, which has lead to the diminished prevalence of sales loads and other transaction-based fees.

This difference sets up a potential conflict: if a broker has a choice between selling a client the mutual fund class (which might carry a commission or ongoing 12b-1 fee) or the ETF class of the same fund (which typically has no load and a lower expense ratio), the client is likely better off with the lower-cost ETF – especially in a taxable account where the ETF may also deliver tax advantages.

Indeed, the SEC has penalized brokers and advisors in the past for keeping clients in higher-cost share classes when cheaper equivalents were available (the Share Class Selection Disclosure initiative being a prime example).

With dual share classes, Reg BI effectively will require brokers to justify any recommendation of a pricier mutual fund class over an otherwise identical ETF class, absent some legitimate basis (for example, if the ETF class is not accessible in the client’s account type, or if the trading costs of acquiring the ETF outweigh the fee differences).

Broker-dealers are already acutely aware of this dynamic. In fact, many broker-dealer firms have been hesitant to approve new ETFs (not just share classes, but ETFs generally) on their product platforms precisely because ETFs do not allow for the revenue-sharing arrangements that mutual funds do.

In other words, brokerage firms have a built-in financial incentive to favor mutual fund classes that kick back a portion of fees (in the form of trailing commissions or sub-transfer-agent fees), whereas an ETF pays them nothing from fund assets. Reg BI does not outright prohibit selling a higher-cost product (commissions are still allowed), but it demands heightened scrutiny and disclosure of conflicts.

Firms may elect to provide training to registered reps about the differences between share classes, emphasizing factors like intraday trading vs. end-of-day pricing, the need for a brokerage account to hold ETFs, and tax considerations – all of which could be cited as legitimate factors in a best-interest analysis.

Investment advisers (such as RIAs) face a similar analysis under their fiduciary duty. Many advisers have already gravitated to fee-based advisory models (charging clients an advisory fee rather than relying on commissions) and have embraced low-cost ETFs in lieu of loaded mutual funds. For those advisers, adding an ETF share class is a natural fit – it gives them another low-cost vehicle for client portfolios without the tax drawbacks of mutual funds. A fiduciary adviser would generally be expected to use the ETF class for taxable clients if it offers a cost or tax advantage.

That said, advisers will also need to consider operational factors: some clients (e.g. in 401(k) or 529 plan accounts) may only have access to the mutual fund class; other clients might value the ability to invest exact dollar amounts (possible with mutual funds, but not with whole-share ETFs). Documentation of share class selection rationale will become an important compliance step.

One practical aspect is that clients who want to hold the ETF class will need a brokerage account capable of trading securities (since ETFs trade like stocks), whereas mutual fund accounts sometimes are held directly with the fund or on recordkeeper platforms.

If a customer is currently invested directly with a mutual fund (or in an insurance/annuity subaccount, etc.), moving to an ETF share class could require opening a new brokerage account. This can be a hurdle for some investors.

Past mutual-fund-to-ETF full conversions have stumbled over this issue, with sponsors having to assist shareholders to migrate to brokerage accounts. In a share-class scenario, the mutual fund class can remain for those unable or unwilling to use a brokerage account, but advisors and brokers should be mindful of this limitation when making recommendations.

In summary, Reg BI and fiduciary standards will force a careful, client-centric approach to offering ETF share classes. The SEC and FINRA will undoubtedly watch how firms implement these changes. It would not be surprising if future examinations specifically review whether firms have adopted policies to recommend the lowest-cost share class (including ETF classes) absent a reasonable basis for an alternative.

Firms should document any instances where a mutual fund class is chosen for reasons such as trading logistics or account type constraints, to defend against potential regulatory second-guessing. Overall, while ETF share classes promise benefits for investors, they also compel distributors to align their practices with investors’ best interests, potentially accelerating the industry trend away from commission-based selling and towards more transparent fee arrangements.

 

Impact on Mutual Funds, Retirement Accounts, and Sponsor Strategies

The SEC’s acceptance of ETF share classes stands to significantly reshape the mutual fund industry, potentially accelerating trends that have been underway for years. Many observers predict a substantial migration of assets from traditional mutual fund shares to ETF shares once the structural barrier is removed.

However, not all mutual fund shareholders will, or should, switch to ETFs. Retirement accounts are the key segment where traditional mutual fund classes are likely to persist. In tax-deferred or tax-exempt accounts (401(k)s, IRAs, pensions), the tax advantage of ETFs is moot – investors don’t pay taxes on distributions or sales until withdrawal, if at all. Additionally, operational features of ETFs are at odds with many retirement plan platforms.

Most 401(k) plans operate on a daily valuation model with fractional shares and omnibus trading: participants contribute dollar amounts that get allocated into fund units carried out to several decimal places.

ETFs, by contrast, trade in whole shares on an exchange, and their prices fluctuate intraday. Many retirement plan recordkeepers lack infrastructure to place intraday trades or handle fractional ETF shares for thousands of participant accounts.

Moreover, plan sponsors often impose rules against intra-day tradable instruments in 401(k) menus, preferring the simplicity and perceived stability of once-daily NAV pricing. For these reasons, retirement plan investors have little incentive to favor an ETF class and in fact might be unable to access it if the plan doesn’t support brokerage windows or similar mechanisms.

The multi-class structure offers a novel solution: a fund complex can maintain conventional mutual fund share classes for retirement accounts while adding an ETF class for other investors, all within the same fund. Because both classes feed into one pooled portfolio, the fund adviser achieves operational scale and efficiency (no need to run a clone strategy in a separate vehicle), but each investor cohort gets the format that suits them. This flexibility is one reason even ETF-centric firms are interested in the relief: for example, several large ETF sponsors have asked for permission to add a mutual fund share class to their existing ETFs, specifically to access retirement plan distribution channels.

If granted exemptive relief, an ETF provider could offer a new share class of an ETF that behaves like a traditional mutual fund share (daily priced, eligible for 401(k)s, possibly carrying a ticker like an R6 share). This reverse dual-class structure would break the “wall” that currently forces retirement assets predominantly into mutual funds. The SEC’s relief is expected to accommodate this two-way flexibility – allowing mutual funds to add ETF classes and ETFs to add mutual fund classes.

What does this mean for the future of mutual funds? In the long run, mutual funds will likely survive but in a narrowed role. They will continue to be the vehicle of choice for retirement and other accounts requiring fractional trading, and for certain distribution channels (e.g. some insurance or bank trust platforms) that are built around the traditional fund model.

Mutual funds may also remain relevant for very small investors or systematic investment plans where the ability to invest, say, $100 per paycheck into a fund is critical (ETFs still aren’t optimal for automated dollar-based investing unless fractional trading is enabled on brokerage platforms).

However, for taxable investors and many advisory clients, mutual funds will lose much of their appeal once ETF share classes are broadly available. The traditional “conversion” of mutual funds to ETFs that some firms have pursued might also slow – conversion entails turning the entire fund into an ETF, which, as discussed, alienates retirement shareholders.

The share class approach is more surgical and arguably shareholder-friendly, since it avoids forcing any group out. Sponsors that were contemplating full conversions might opt instead for adding an ETF class to achieve tax efficiency while keeping existing shareholders onboard without disruption.

For fund sponsors, the advent of ETF share classes will shape their future competitive strategy. Established firms with large mutual fund franchises (and large embedded shareholder bases) likely view share classes as a mechanism to stem asset bleed to third-party ETFs. They can offer their clients the same strategy in ETF form, thus retaining assets that might otherwise migrate to an ETF from a competitor. These firms will need to carefully decide which funds get an ETF class first – candidates are typically those with substantial taxable assets and high unrealized gains (to maximize the tax benefit) and those in popular or scalable categories like U.S. equity or broad fixed income.

Less liquid or more niche funds might be low priority or avoided if the arbitrage and transparency requirements are hard to meet. Smaller fund complexes, for whom supporting an ETF class might be operationally daunting, could take a wait-and-see approach or partner with white-label ETF platforms to implement the share class.

 

Looking Forward

In conclusion, the broad acceptance of ETF share classes by the SEC – which appears imminent – would mark a transformative moment for the investment management industry. It will blur the lines between two product structures that have historically been distinct, marrying the convenience and familiarity of mutual funds (for certain channels) with the efficiency and marketability of ETFs. Investors stand to gain from greater choice and potential cost savings, but they will also face new considerations (such as whether to hold an investment via the ETF or mutual fund class).

Fund sponsors and intermediaries, for their part, will need to navigate the complexities outlined above: ensuring fairness between classes, upgrading operations, adjusting their distribution models, and addressing regulatory duties in the face of changed incentives. The SEC’s evolving stance – from early exemptions, to a cautious rule in 2019, to the current openness – reflects a balancing of innovation against investor protection.

If executed properly, the ETF share class structure could indeed deliver a “best of both worlds” outcome, but success will depend on careful compliance and oversight, as well as the willingness of market participants to adapt their long-held practices.

Compliance and legal professionals should keep a close eye on the first exemptive orders and their conditions, as those will set the template for this new landscape in which mutual funds and ETFs co-exist as share classes of the same fund. We are on the cusp of a new era where the traditional mutual fund finds a second life (and improved value proposition) by embracing the ETF format within a unified product.

The information contained in this document is provided for informational purposes only and does not constitute legal, tax, or investment advice. Readers should consult their own legal and tax advisors for guidance specific to their firm’s circumstances. The content herein is subject to change without notice, and PINE makes no representations or warranties regarding the completeness or accuracy of the information. PINE is not liable for any decisions made or actions taken based on this material.

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