News: The Patent That Helped Vanguard Clients Pocket Big Gains Expires

The patent that has given Vanguard Group a competitive advantage over its rivals for the past two decades, resulting in over $100 billion in additional investment gains for its clients, has expired today.

With the expiration of the patent, other fund managers are now free to replicate the unique but controversial fund structure pioneered by the firm founded by Jack Bogle in 2001. This structure allows mutual funds to function like exchange-traded funds (ETFs), generating returns for investors while minimizing taxes.

It remains uncertain whether the expiration of the patent is a minor event in history or a significant moment for fund managers seeking a fresh edge in an increasingly competitive market. The US Securities and Exchange Commission (SEC) plays a pivotal role in determining the outcome. Just because the SEC allowed Vanguard to use this tactic two decades ago does not guarantee that it will permit others to do the same now.

Nate Geraci, president of The ETF Store, an advisory firm, emphasized the importance of the SEC's decision, stating, "The SEC is the clear lynchpin here. If they give the green light to this structure, I expect many traditional mutual fund companies to seriously consider using it."

For companies to utilize the fund structure and gain mutual funds access to the tax efficiency of ETFs, they need the SEC to grant them exemptive relief from current regulations. Jeremy Senderowicz, a shareholder at law firm Vedder Price, highlighted that the SEC is under no obligation to grant such relief and there is no guarantee of a specific timeframe for feedback from the SEC.

So far, only one other company, PGIA, the US-arm of Australian asset manager Perpetual Ltd., has requested that the SEC allow ETFs as share classes of its actively-managed mutual funds. This differs slightly from Vanguard, which has only used the structure in index-following funds.

Robert Kenyon, the chief operating officer of PGIA, described the interaction with the SEC as constructive and anticipates a response from the regulator in August. The SEC declined to comment on the matter.

Prior to the expiration of the patent, the ETF-within-a-mutual-fund structure was available only to issuers who agreed to a licensing arrangement with Vanguard and obtained exemptive relief from the SEC. However, no other fund managers have succeeded in utilizing this structure. VanEck filed for exemptive relief to offer index ETF share classes in 2012 and 2015 but was never granted permission.

Considering the significant growth of the ETF industry, it remains unclear how much demand there will be for the new structure. In 2022, according to Bloomberg data, the gap between outflows from mutual funds and inflows into ETFs reached a record $1.5 trillion.

Most major fund issuers now offer ETFs, which are popular with investors due to their accessibility and lower trading costs. Additionally, there has been a recent trend of converting billions of dollars of mutual fund assets into ETFs.

Douglas Yones, head of exchange-traded products at the New York Stock Exchange, revealed that several other asset managers plan to file with the SEC for permission to create exchange-traded funds as a share class of mutual funds. Yones assists managers with complex or novel filings requiring SEC approval and is engaged in exploratory conversations to discuss the potential structure of a multi-share class ETF.

In recent years, US regulators have introduced rule changes to facilitate the launch of ETFs, and the SEC intentionally retained the requirement for issuers to seek an exemption if they want to pursue ETFs in a multiple share class structure.

If the SEC does not permit this structure for additional asset management firms, concerns may arise about whether the SEC is perpetuating an uneven playing field by granting exclusive use of this expired patent to the already dominant Vanguard, warned Geraci.