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The Markets September 7, 2023
Can ETFs Work in 401(k)s With Mutual Fund Rebranding?
F/m Investments has asked the SEC for the right to classify an ETF series as mutual funds to be accessible for 401(k) participants.
Reported by Alex Ortolani
An investment firm is seeking to make an exchange-traded-fund series available to a wider swath of investors, including defined contribution plan participants, by getting them classified as mutual funds—the reverse of a trend toward getting mutual funds classified as the more popular ETFs.
F/m Investments LLC, a subsidiary of Diffractive Managers Group LLC, filed the request with the Securities and Exchange Commission in August in what firm president and CIO Alex Morris says is “swimming the opposite way from the crowd.”
“As we looked at it, we recognized that the $6 trillion 401(k) DC/DB space is really cut out of the innovation that’s happening on the ETF side of the house and that the best way to cut them in was to find a way for ETFs to participate in mutual funds,” he says. “It was not to do the other thing, which was to find a way for mutual funds to effectively earn a tax dodge.”
The “exemptive relief” application calls on the SEC to allow F/m’s U.S. Benchmark Series, a suite of 10 ETFs that provide investors with exposure to one of the “benchmark” U.S. Treasury securities, to be listed in the mutual fund share class. While Morris and team have not received a response from the SEC, they are hopeful of having a dialogue within a 90-day window from the proposal’s submission.
The Right ETFs
The move by F/m Investments reverses a trend in which mutual funds are being converted to ETFs to take advantage of investor inflows going more to ETFs in recent years than mutual funds (which are often seeing outflows), according to Morningstar data. In terms of those conversions, Fidelity Investments reports that more than 50 mutual funds with $60 billion in assets have converted to ETFs since March 2021.
F/m Investments’ pitch to the SEC relies, in large part, on the type of ETF series they are proposing, according to Aisha Hunt, a principal in and the founder of law firm Kelley Hunt & Charles, which worked with the firm on the proposal. The firm’s U.S. Benchmark Series is made up of U.S. Treasury securities, cash and cash equivalents, and would be available in a daily accrual offering—as opposed to intraday—if allowed by the SEC.
“The SEC has really emphasized that their determination around issuing this exemptive relief is facts- and circumstances-driven, and they’ve been very explicit about that,” Hunt says. “We were very fortunate that the U.S. Benchmark Series has the best facts and circumstances for making the case that the SEC should consider approving adding a mutual fund share class to an ETF family.”
One of the SEC’s biggest concerns is a “cash drag” for the ETF shareholders should the mutual fund share class reserve cash to meet cash redemptions, Hunt explains. The ETFs with single-issue Treasurys would not disrupt portfolio management, because they are holding highly liquid Treasurys.
“That’s why the benchmark series really presents the best facts and circumstances to make the case to add a mutual fund share class,” Hunt says.
On the flip side, the ETF shareholders can then benefit from “a larger asset pool and greater economies of scale, as you can spread fixed costs across a greater asset pool,” Hunt notes.
Another key part of the application, according to Hunt, is that unlike other ETF issuers or mutual fund managers, F/m Investments is proposing that a mutual fund share class and the ETF share class would charge the same “unitary fee.”
“The unitary fee, unlike a traditional mutual fund fee schedule, requires the manager to pay other fund expenses,” she says. “There wouldn’t be any subsidization where mutual fund shareholders or ETF shareholders would be paying for other expenses; the manager would be paying the fees under the unitary fee structure.”
Swimming Upstream
Morris says the firm’s push to make an ETF a mutual fund, as opposed to the other way around, comes in part from an ethos of not necessarily “going faster,” but thinking differently.
He notes that the firm was “getting laughed out of a lot of rooms” for the initial launch of a single-Treasury ETF. Now, slightly more than one year later, it has more than $2.5 billion in investments and is being requested as a mutual fund to be included in DC plan investments, he says.
“In the short term, our thought process was pretty simple,” Morris says. “We’ve got a fund that has had demand from the retirement space. Our options were to start a new fund and wait for five years for it to be effective or see if we could allow folks to join in on the innovation and success of this ETF practice.”
Along with the exemptive relief application, F/m Investments has filed a provisional patent application to protect its creation, according to the firm.
There is precedence for retirement plan providers including ETFs in workplace plans. The 2023 PLANSPONSOR Defined Contribution Benchmarking Report found that 0.4% of retirement plans offer exchange-traded funds in their investment lineup, compared with 55.5% in mutual funds and 23.1% in collective investment trusts.
When asked about whether proposing other ETFs, such as those that invest in stocks, would come next, Morris of F/m Investments said they were focused, for now, on this particular series. He did champion the idea of getting ETF offerings to retirement plan participants in the future.
Attorneys from Ropes & Gray LLP, when commenting on the proposal, noted the significance of the application only applying to F/m’s suite of Treasury ETFs.
“Given the novel relief requested by F/m, we expect that applicants seeking similar relief will need to engage with the [SEC] to work through the issues raised by the proposed structure,” the firm’s comment stated.
Overall, the attorneys wrote, “we continue to believe that the ability to offer investors the choice of an ETF share class and a mutual fund share class in the same vehicle would provide significant benefits to shareholders.”
Meanwhile, the question of whether F/m Investments’ proposal gets a serious hearing should be determined in coming months. The SEC did not respond to a request for comment on the proposal.
