Exchange Thoughts - The Rise of Listed and Unlisted Share Classes

November 09, 2020
Thanks to evolving regulatory policy in Europe and Hong Kong, more asset managers are considering adding unlisted share classes to their ETFs. We lay out the top considerations for launching unlisted share classes on existing ETFs.

Innovation and exchanged traded funds (ETF) are words that have become synonymous in recent years. Evolving regulatory policy in Europe and Hong Kong, has meant that more asset managers are considering launching listed and unlisted share classes within the same umbrella.   For these ETF managers, this product innovation may create additional distribution opportunities for established products, which potentially lead to increased inflows and offer more choice to investors.

For funds that launch both listed and unlisted share classes (what we are referring to as co-mingled funds) all share classes are part of the same legal structure, follow the same investment strategy, and have the same investment manager. In addition, they have the same underlying assets and valuation policy.

The key structural differences between listed and unlisted share classes is that the listed share classes are traded on exchange. Investors buy the product through their broker at a price determined by market supply and demand and facilitated by a market maker, whereas the unlisted share classes are purchased directly from the fund at NAV. Also, depending on the applicable regulatory structure, most listed share classes are required to publish their holdings daily and, depending on the exchange where they are listed, publish an indicative NAV (iNAV/IIV) throughout the day.

Regulatory and Policy Landscape

The Luxembourg regulator, Commission de Surveillance du Secteur Financier (CSSF), has approved the launch of listed and unlisted share classes within the same sub fund.  Some asset managers such as Amundi and BNP have launched Luxembourg domiciled product in recent years, all of which have successfully gathered assets through this co-mingling process.

In 2018, the Central Bank of Ireland (CBI) provided asset managers greater opportunity to launch ETFs with co-mingled share classes.  Following this policy change, the CBI has approved existing ETFs to launch subsequent unlisted share classes. Because the majority (>60%) of European ETFs are domiciled in Ireland, this move by the CBI has created a lot of interest among European asset managers with Irish domiciled ETFs.

The CBI has not yet approved mutual funds to launch listed share classes but we understand they are taking submissions from the industry regarding this structure. These discussions are ongoing, but we do expect more to come from the CBI in the coming months.

The Securities and Futures Commission (SFC) in Hong Kong followed suit in January 2019, allowing both listed and unlisted share classes within the same sub fund. China International Capital Corporation Hong Kong Asset Management Limited was among the first issuers to add unlisted unit classes to their lineup of ETFs listed on HKEX.

In the US market, the future of this particular ETF design is a somewhat uncertain. Vanguard is currently the only asset manager that can launch an ETF as a share-class (listed) of a mutual fund (unlisted), largely stemming from the patent the firm has on this structure. Additionally, the SEC has carved out these ETFs from its ETF Rule (rule 6c-11), meaning firms seeking to adopt this structure will still need explicit regulatory approval to do so.

Benefits of comingling Listed and Unlisted Share classes

“The possibility of an ETF to establish an unlisted unit class provides an additional distribution channel via the primary market. This is proven to be an innovative product structure that allows a complete set of investment options that cater for the diverse needs of the investing community.” --  Lin Ning, Managing Director of China International Capital Corporation Hong Kong Asset Management Limited

There are four major benefits of launching sub funds with both listed and unlisted share classes, namely:

  1. They provide investors with both listed and unlisted options to access the same investment strategy from which they can choose the best fit for their investment needs.
  2. They can open doors to both legacy and emerging distribution channels with private banks, retail platforms, and institutional investors who may see growing interest in listed share classes.
  3. They help achieve economies of scale for the issuer since the costs to launch a new share class are much lower than launching a new sub-fund. Also, the time to market for a share class is also far quicker than for a sub-fund.
  4. They allow investors to leverage performance history of the existing share classes. According to BBH’s 2020 Global ETF survey, historical performance is the top criteria for ETF selection globally. Many ETF investors will look for performance history as part of the fund selection process.

Considerations for Asset Managers if Launching Comingled Share Classes

Before launching a structure with both listed and unlisted share classes, there are some key considerations for asset managers.

Some fear it could cannibalise existing mutual funds: Some asset managers argue that launching ETFs would cannibalise their existing mutual fund business. While the comingled share class structure is in its infancy, there are examples of asset managers who have the same strategy in mutual funds and ETFs which has not led to significant outflows from mutual funds into their ETF equivalent products. Launching an ETF share class can be considered a defensive play, especially for managers who are under pressure with outflows of assets from their mutual funds into ETFs. Also, it provides an additional distribution channel for the same strategy, thus, providing additional options for investors.

Getting firms ‘ETF ready’: managers with mutual funds who launch an ETF share class need to build out their infrastructure and operating model to support ETFs. Examples include disclosure of the portfolio holdings as required under the fund’s regulatory regime, implementation and oversight of ETF specific workflows and assigning or hiring capital markets personnel.

Ability to leverage existing distribution network: The selling of mutual funds and ETFs require different levels of expertise and compensation structures. Asset managers should consider how to leverage their existing distribution network to sell both the listed and unlisted share classes as there are significant economies of scale for those who can achieve it. 

Tax implications: Depending on the domicile, the market, and the security, an ETF may have access to double taxation treaties which can make significant positive impact on performance. Asset managers should consider the potential impact on accessing these treaties with the launch of listed and unlisted share classes within the same umbrella.

Shareholder treatment: Issuers should take the necessary steps to limit the impact of order activity on one group of shareholders versus another. For example, to minimise the impact to existing investors due to order activity, swing pricing is typically applied in mutual funds/unlisted share classes. The direction of the swing being dependent on whether there is net subscription or net redemption activity on the fund. For ETFs, generally the actual cost of trading the basket (or NAV plus a variable fee) is applied to each creation and redemption order and paid by the fund’s Authorised Participants (APs).  Asset managers who launch listed and unlisted share classes may decide to apply swing pricing to the unlisted share class only and NAV+ or actual costs to the listed share class. 

Fund Service Provider’s ability to support both listed and unlisted share classes within the same structure should be closely considered (i.e. NAV production, transfer agency, and custody).   Areas to consider include:

  • Are fund accounting and transfer agency systems set up to handle the unique operational nuances of supporting listed and unlisted share classes?
  • If required, can the fund accounting agent provide swing pricing on the unlisted share class?
  • Does the investment manager require amalgamated reporting to manage both classes and if so, can the service provider deliver?  

There are many considerations for an asset manager when assessing listed and unlisted structures. These changes in regulatory policy has many potential benefits for issuers and investors, providing more product choices, access to new distribution channels, and minimizing cost to managers/investors.

Over the past 15 years, Brown Brothers Harriman (BBH) has partnered with more than 40 asset managers and Sponsors to bring ETFs to market in the US, Europe, and Hong Kong. BBH has partnered with leading asset managers and has developed the expertise, technology, and operational processes to supported commingled unlisted / listed structures. BBH would welcome the opportunity to discuss this product feature and help you assess the feasibility for your product and distribution strategy. 

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