Investors have long heard about the differences between mutual funds and ETFs, but the rise of ETF share classes of mutual funds shows what can happen when asset managers combine potentially the best features of both.
Below, we’ll break down the basics of ETF share classes, their potential benefits and drawbacks, and how investors may consider approaching this evolving structure.
What is an ETF share class?
An ETF share class is basically a version of a mutual fund wrapped in an ETF structure. It holds the same funds as the mutual fund but gives investors the flexibility to buy and sell shares throughout the trading day like an ETF.
This structure has been around for a while, but it has only recently gained traction. Since 2023, more than 75 asset managers have filed for SEC approval to offer ETF share classes of their own.1
The idea behind this movement is to give investors professionally-managed strategies found in a mutual fund with the efficient and flexible framework of an ETF.
It also can make sense for asset managers who see billions of dollars continue to funnel out of mutual funds and into ETFs. In 2024 alone, mutual funds recorded $388 billion in outflows, while new money into ETFs broke $1 trillion.2
Benefits and drawbacks of ETF share classes
Potential benefits for asset managers
Part of the motivation surely comes from the industry’s broad move from mutual funds into ETFs, and rather than start a new ETF from scratch, an ETF share class allows asset managers to extend an existing mutual fund’s strategy, history, and brand recognition into an accessible structure.
Potential benefits for investors
It’s not just asset managers who may benefit from ETF share classes, either. There could be potential benefits for investors too.
- Because an ETF share class is tied to an existing mutual fund, investors should have a clear track historical record to review when making investment decisions. Of course, like any investment, there’s no guarantee that past performance of any investment is an indication that such investment will achieve similar results in the future.
- Also, ETFs can generally be more tax efficient than mutual funds. That’s because of the way shares are created and redeemed in an ETF. Unlike mutual funds, which generally buy or sell securities when investors add or withdraw money, ETFs can create or redeem shares in kind by exchanging securities rather than cash. This structure can help minimize the capital gains distributions investors might otherwise face in comparable mutual funds.3
- Shareholders of the mutual fund share classes can also benefit from the addition of an ETF share class. The in-kind creation and redemption process from ETFs lets the fund manager sell holdings with pent up capital gains, without having to distribute capital gains to mutual fund owners.
Potential drawbacks
- An ETF share class of a mutual fund may not capture all of the tax efficiencies of a standalone ETF. Because it shares a portfolio with the mutual fund, activity within the mutual fund can sometimes trigger capital gains that are passed through to investors in the ETF share class.4
- Unlike a traditional ETF, which discloses holdings daily, some mutual fund managers may not want to peel back the curtain, even for the ETF share class. This is more likely to happen with an active mutual fund or one that tracks a proprietary index.
- In some cases, an active mutual fund manager may even stop taking in new money to avoid having more assets than they can manage effectively. With an ETF share class, there is no way to deny new investors.
- The cash balances a mutual fund maintains for shareholder redemption can put a drag on performance for an ETF share class, compared with a standalone ETF without a parent mutual fund.
What can investors consider?
ETF share classes aren’t going anywhere. With Vanguard’s patent in the rearview and investors piling into ETFs, many asset managers are eager to keep up with the shift in investor behavior, and that may likely materialize into more ETF share classes.
Investors may want to get comfortable with this trend, and even the reverse: a mutual fund share class of an ETF. Since ETFs haven’t been the default option in 401(k)s and other retirement plans, some ETF managers may consider adding a mutual fund share class to reach more retirement investors.
As with any investment, pay attention to the details, whether you're an existing shareholder or considering a new position.
- Think about the pros and cons of an ETF share class of a mutual fund compared to a standalone ETF.
- If you own shares in a mutual fund that’s adding an ETF share class, consider the potential impact on your investments.
- Ask yourself whether you should do nothing, move to the ETF share class, or exit the fund altogether. Since everyone’s situation is different, there’s no single right or wrong answer, but taking the time to understand how ETF share classes work can help you make an informed decision.
As for us at Motley Fool Asset Management, we’ve long been fans of ETFs. Explore our lineup of ETFs to see how they may fit with your investment goals.
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