Against this backdrop of surging investor interest, regulatory developments are taking center stage. Notably, the expiration of the long-standing industry ETF patent in May 2023 sparked renewed interest among asset managers in creating mutual funds that include both traditional mutual fund shares and ETF share classes, a structure often called a dual share class. As of mid-2025, more than 70 asset managers have submitted applications to the US Securities and Exchange Commission (SEC) seeking exemptive relief to establish ETF share class structures for their existing mutual fund families.

Although the SEC has yet to approve any new ETF share class products, industry participants such as Dimensional Fund Advisors (DFA) amended their original filings to address initial regulatory concerns raised by the SEC. Many industry observers anticipate that the first approvals could happen in the coming months, but this hinges on favorable regulatory action. A long line awaits the potential benefits of offering ETFs as a share class within a mutual fund structure, including enhanced tax efficiency, broader investor access, and operational synergies, which may make the wait both worthwhile and lucrative for asset managers willing to navigate the evolving landscape.

Another key item to consider is that under the proposed share class relief, it is anticipated that a fund’s board must approve that the multi-share class structure is in the best interest of the shareholders (which is the case today for any registered open-end investment company). Along with this, there are a number of items relating to this relief that the board may want to consider, in combination with the adviser, to ensure fairness among the differing classes in terms of how transactions are processed either through cash or in-kind transactions, among other items. DFA addressed the SEC’s concerns in its amended filings, proposing a governance structure with an independent board responsible for assessing the benefits of an ETF share class for shareholders and the continued monitoring for cross-subsidization and cash drag once the dual share class is live.

Additionally, the board will need to issue the periodic adviser report, to annually assess and confirm that the dual class structure continues to be beneficial for both the mutual fund and ETF share class investors. These anticipated new governance requirements for fund management and the fund board will take careful conversations and consideration to ensure that the SEC’s expectation of active board oversight is achieved.

A major advantage of the ETF share class structure is the enhanced tax “efficiency” it offers to both ETF and mutual fund shareholders. By leveraging custom in-kind redemptions baskets (CIKRs), this approach significantly reduces or eliminates the distribution of capital gains tax to all investors. Significant redemptions or cash rebalances within the mutual fund share classes could result in the fund having capital gain distributions however, and these would be shared between the ETF and mutual fund share classes, which may be an unexpected result for ETF shareholders.

Funds should consider the amount of built-in gains within the fund, existing tax attributes such as undistributed gains or capital loss carryovers, and their ability to manage the fund distributions through tax-loss harvesting. Funds should also consider the current makeup of their shareholder base (qualified versus unqualified accounts) and the demand for ETF share class. The smaller the ETF share class is relative to the overall size of the fund, the less impactful the CIKR mechanism will be. There are also investment strategies, such as those that use a significant amount of derivatives, which can reduce the “tax efficiency” provided by the CIKR feature.

One of the primary considerations when launching an ETF share class of a mutual fund is evaluating the potential impact on accounting and financial reporting for both the ETF and mutual fund. The initial conversion of mutual fund shares into ETF shares represents a key transaction that must be carefully accounted for. It is important to note that while investors may convert mutual funds into ETF shares at launch, the reverse—converting ETF shares back into mutual fund shares—is not permitted.

Establishing and accounting for the in-kind creation and redemption mechanism is also essential, particularly for asset managers who have not previously launched an ETF. For those with prior ETF experience, introducing an ETF as a share class generally presents less risk than launching a stand-alone ETF. This is because the new ETF share class can leverage the established fund’s performance history, investment strategy, and existing operational programs, such as securities lending and established relationships with authorized participants (APs), who play a critical role in facilitating in-kind transactions and maintaining ETF liquidity.

Another important capability is the ongoing monitoring and mitigation of “cross-subsidization,” as referenced by the SEC. Cross-subsidization can occur when large redemptions in the mutual fund share class trigger capital gains distributions that also affect ETF shareholders. 

The operating model and investment strategy for an ETF share class generally mirrors that of other ETFs, but there are nuanced differences in the approach to index rebalancing and corporate actions. Asset managers may want to utilize CIKRs to help avoid realizing capital gains taxes associated with rebalancing or corporate action. As asset managers consider launching an ETF share class, it is important to evaluate and enhance existing capabilities, particularly the integration of ETF and mutual fund operations, to support increased transparency and effective monitoring.

The introduction of ETF share class launches will require greater coordination between traditional fund front office and operations and the capital markets teams and ETF operations. This includes training traditional fund portfolio managers on the utilization of in-kind transactions, the timing and reflection of in-kinds in the IBOR (Investment Book of Record), as well as the interaction model with the capital markets team. The operating model within the front office and operations teams will need to be enhanced, enabling greater coordination between portfolio managers, capital markets, and operations. Firms may look to utilize a basket creation team within their capital markets desk to identify opportunities for CIKRs across ETFs and mutual funds with ETF share classes.

In particular, firms should look to coordinate across their front office desks and investment teams when large voluntary corporate action decisions arise to facilitate in-kind transactions inclusive of the mutual fund holdings. Voluntary corporate actions and the index rebalancing period present opportunities for securities to be redeemed via CIKR to prevent capital gains being realized and passed on to the shareholders. Active ETF share classes will present more complex challenges for coordination with the capital markets group as they utilize custom baskets at significantly higher rates than passively managed ETFs. It should be noted that these opportunities and the higher volume of CIKRs also present increased risk as the custom basket process can be highly manual and requires rigorous oversight, clear roles and responsibilities, and strong controls to prevent operational errors.