Is the Industry Ready for an ETF Share Class?

Introduction

On 29 September 2025, the US Securities and Exchange Commission (SEC) issued notice¹ of an exemptive application² filed by Dimensional Fund Advisors LP, et al. (Dimensional) seeking relief (Relief) to offer index-based or actively managed funds that have one or more mutual fund share classes and an exchange-traded fund (ETF) share class (Dual Class Funds). Under the Relief contemplated, an existing mutual fund could add an ETF share class or an existing ETF could add mutual fund share classes; and in each case, mutual fund class holders may exchange their shares for ETF class shares on a tax-free basis (Exchange Privilege). To protect the arbitrage mechanism underlying the ETF class shares, a Dual Class Fund’s mutual fund shares must not be listed on any securities exchange, and a Dual Class Fund “will not permit or facilitate, a secondary market for, peer-to-peer trading of, or quotation on any quotation medium” of, its shares (other than as described in the Application).

If the SEC does not receive a hearing request on the Notice, Dimensional should receive its order in approximately 15 days after the SEC’s publication of the Notice in the Federal Register. Immediately thereafter, the SEC Staff is expected to have delegated authority to grant orders on the dozens of other pending applications, provided that they are “substantially the same” as the Dimensional model.

Dual Class Funds: A History

In the mid-2000s, the SEC issued a series of exemptive orders that permitted one fund sponsor (VGI) of index mutual funds to add an ETF share class and to permit shareholders of the mutual fund classes to exchange into the new ETF class, tax-free.³ At the same time, VGI obtained a patent for the structure, which dissuaded other fund sponsors from using it–although many may have liked to do so, given its potential to enhance a fund’s tax efficiency.⁴ 

Approximately ten years later, VGI approached the SEC to obtain the same exemptive relief for their actively managed mutual funds–relief to permit such funds to add an ETF share class and allow shareholders of the mutual fund classes to exchange into the new ETF class, tax-free. Somewhat surprisingly, the SEC declined to grant the relief. In so doing, the SEC for the first time signaled that it had potential regulatory concerns about Dual Class Funds.

In 2019, in the adopting release for the ETF Rule (Adopting Release), the SEC made such concerns explicit.⁵ There, the SEC clarified that Dual Class Funds could not operate in reliance on the ETF Rule because they require relief from Section 18 of the Investment Company Act of 1940 (1940 Act); and, the SEC said, the ETF Rule does not provide such relief. In addition, the SEC explained why the ETF Rule does not include such relief: 

[R]elief from section 18 raises policy considerations that are different from those we are seeking to address in this rule. For example, an ETF share class that transacts with authorized participants on an in-kind basis and a mutual fund share class that transacts with shareholders on a cash basis may give rise to differing costs to the portfolio. As a result, while certain of these costs may result from the features of one share class or another, all shareholders would generally bear these portfolio costs.⁶

In short, the SEC identified cross-subsidization as the key policy concern presented by Dual Class Funds.  

Further, the SEC indicated that its focus was the potential subsidization by an ETF class of mutual fund classes in a Dual Class Fund. In this regard, the SEC called out certain traditional, fund-level costs that ETFs largely avoid and that, therefore, may result in such cross-subsidization.  

These costs can include brokerage and other costs associated with buying and selling portfolio securities in response to mutual fund share class cash inflows and outflows, cash drag associated with holding the cash necessary to satisfy mutual fund share class redemptions, and distributable capital gains associated with portfolio transactions.⁷

The SEC also observed that Dual Class Funds do not provide daily portfolio transparency, whereas ETFs that operate in reliance on the ETF Rule are required to provide daily portfolio transparency.⁸ 

In 2023, around the time that the VGI patent expired, dozens of fund sponsors filed exemptive applications to offer Dual Class Funds, proposing terms and conditions they believed would mitigate the SEC’s cross-subsidization and transparency concerns. The SEC issued notice of its intent to grant Relief for Dual Class Funds for the first time in almost 20 years based on the Application filed by Dimensional.  

If the SEC does not receive a hearing request on the Notice, Dimensional should receive its order approximately 15 days after the SEC’s publication of the Notice in the Federal Register. Immediately thereafter, the SEC Staff is expected to begin issuing copycat notices and orders to all applicants that file exemptive applications that are “substantially the same” as the Dimensional model.⁹  

Dual Class Funds: Terms and Conditions

The primary hurdle to obtaining exemptive relief for Dual Class Funds was overcoming the SEC’s concerns about cross-subsidization and transparency. 

Transparency

Dimensional dispensed with the SEC’s transparency concerns quite easily by agreeing to provide the same daily portfolio transparency as is required by the ETF Rule for all classes of the Dual Class Fund.¹⁰

Cross-Subsidization

At a high level, Dimensional treats cross-subsidization as a conflict of interest that can be addressed with robust board oversight.  It then agrees to detailed requirements for such board oversight in the form of three-stage reporting by the adviser to the board, followed by the board’s approval, amendment or renewal, as applicable, of a multi-class plan (Plan) for a Dual Class Fund.¹¹ 

The three-stage reporting required includes an Initial Adviser Report, an Ongoing Monitoring Process pursuant to which the board will receive other reports and, finally, an Ongoing Oversight Report. This alert discusses each in order.

The Initial Adviser Report must provide the following information:

• A cost-benefit analysis of the structure for each class and the fund as a whole, addressing at a minimum:
  • Potential cost savings and other benefits of operating pursuant to the Plan; 
  • How each of the ETF class and mutual fund classes will be affected by reasonably expected:
    • Cash flows and costs associated with portfolio transactions;
    • Cash levels;
    • Distributable capital gains; and
    • (For existing funds only) realization, and the extent thereof, of any unrealized capital gains/losses or carry over capital losses;
• A discussion of how the costs of transitioning to the Dual Class Fund structure will be mitigated and allocated; 
• An explanation of why a fund’s investment strategy is appropriate for the Dual Class Fund structure (e.g., is not subject to portfolio transparency or capacity constraints); and 
• A discussion of all other material conflicts of interest, including sources of potential cross-subsidization, identified by the adviser.

Based on the Initial Adviser Report and a presentation on the Ongoing Monitoring Process (as defined below), the board must initially approve the proposed Plan.¹²

Thereafter, the Ongoing Monitoring Process begins. The Ongoing Monitoring Process uses a board-approved framework to monitor a Dual Class Fund’s operating in the manner contemplated in the Initial Adviser Report or, if different, in a manner that is in the best interest of the Fund as a whole and of each share class separately.¹³ Both the adviser and the board may reasonably expect to evaluate the successful operation of a Dual Class Fund based on the Ongoing Monitoring Process. 

To establish the Ongoing Monitoring Process, the adviser must recommend to the board numerical thresholds to be used to evaluate a Dual Class Fund, the method for calculating such thresholds, and the time periods over which to measure the Dual Class Fund’s performance against the thresholds (Threshold Measurement Periods). Such thresholds may be based on the adviser’s historical experience with similar funds, if available and relevant. Such thresholds must be designed to help identify material conflicts of interest between the ETF share class and the mutual fund share classes, including in terms of the costs each class is bearing in the dual class structure (e.g., portfolio transaction costs, cash drag and capital gains realizations).¹⁴ If a threshold is exceeded, the adviser must:

• Notify the board (or a designated committee or member thereof) within 30 days of the end of the relevant Threshold Measurement Period; and 
• Provide the board with a written assessment of the exceedance and recommendations, if any, for remedial action.

Once a Dual Class Fund starts operating pursuant to a Plan, the adviser at least annually must prepare for the board an Ongoing Adviser Report,¹⁵ which may be analogized to an updated cost-benefit analysis (or updated Initial Advisor Report). The Ongoing Oversight Report must include the following information:

• A discussion of the benefits, including cost savings, to each class of the dual class structure;
• For each class, a discussion of the material negative consequences and material conflicts of interest of the dual class structure, including:
  • How creation and redemption activity in the ETF class has affected the mutual fund class(es) and how purchase and redemption activity in the mutual fund class(es) has affected the ETF class, in each case with respect to cash levels, short- and long-term capital gains distributions, and costs associated with portfolio transactions;
  • Any performance difference between the mutual fund class(es) and the ETF class due to a difference in dividend declaration and record dates;¹⁶ and
• Any other information that the board requests.

Based on the Ongoing Oversight Report, the board must evaluate each Dual Class Fund’s structure and find that the Plan continues to be in the best interests of each class and the fund as a whole or approve amendments to the Plan that allow it to find that the Plan is in the best interests of each class and the fund as a whole.¹⁷ 

Conclusion

Overall, the terms and conditions of the Relief provide the industry with significant flexibility on how to operate Dual Class Funds and seem designed not to disrupt board oversight of traditional multi-class mutual funds.¹⁸ Further, they appropriately impose the heaviest burden for oversight of the Dual Class Fund structure on the adviser (and not the board) by requiring the adviser to identify for the board the conflicts presented by the structure and provide the board with all material information relevant to its oversight function.