Posted by Jack Taylor and Tom Cummings
There has been growing buzz around the undeniable surge in the ETF share class and digital asset ETF applications within the Investment Company Act of 1940 (’40 Act) and 1933 Act Securities Act (’33 Act) structures. As these innovative offerings gain traction, issuers and service providers are evaluating how these developments could affect their roles within the investment company ecosystem.
In the coming months, the SEC is expected to make decisions on the ETF share class applications and has asked issuers to review the DFA application. The Dimensional Fund Advisors’ application is a formal request to the SEC for exemptive relief that would allow offerings of ETF share classes within existing mutual funds. In addition, the SEC is evaluating a number of digital asset products that have been applied for — and the investment company industry is watching closely. At our recent Cohen Client Conference, panelists discussed the complexities, implications and opportunities tied to each of these topics. We’ve summarized the engaging discussion below.
The ETF share class is not new to the world of investment companies. In fact, Vanguard has been using this structure within their own investment company complex since 1999, using a patent and SEC exemptive relief to offer ETF share classes to mutual funds. With the expiration of the patent in May 2023, other asset managers are now more incentivized to get relief. Combining this with the rapid growth of the ETF market and rising investor demand, the industry is seeing a flood of ETF share class applications, with over 50 applications submitted to the SEC.
The ETF share class structure has the ability to offer tax advantages when included within a mutual fund framework. Thanks to the in-kind redemption feature, ETF wrappers allow advisers to minimize capital gain distributions, which is a benefit that ultimately passes through to investors. It is important to note, though, there are cross-subsidization risks between mutual fund and ETF share classes within the same fund. For example, if an investor is solely invested in the ETF share class of a mutual fund, that same investor may be subject to taxable distributions coming from capital gains realized in the mutual fund share classes that exist within the fund.
However, it’s also important to note the significant operational lift the ETF share class structure brings. One key consideration is the relationship between mutual fund advisers and market makers or authorized participants (APs). Advisers must have clear controls and communication protocols in place for handling in-kind basket creations and redemptions. This function is a core operational requirement of an ETF. The coordination between the mutual fund and ETF transfer agents is also important. With investors potentially holding shares across multiple classes, transfer agents must be able to adapt systems to support investor elections, transaction processing, and accurate record-keeping across both mutual fund and ETF platforms.
A final thought on the ETF share class revolves around compensation structure for distributors. In a traditional mutual fund, distributors are often compensated through 12b-1 fees or front-end/back-end loads. However, ETFs — especially when offered as a share class within a mutual fund — do not typically support these compensation models. This discrepancy raises the important question: What incentive do distribution platforms have to promote the ETF share class? Without clear compensation structures, distributors may lack incentive to prioritize ETF share class products, despite their tax efficiency and growing investor interest. As a result, asset managers may need to explore alternative compensation models or educational initiatives to align distributor incentives with investor demand.
The SEC’s evolving role in digital asset regulation centers on two main product types: those registered under the ’33 Act and those registered under the ’40 Act. Since the SEC classifies bitcoin and ether as commodities, funds investing directly in these assets must register under the ’33 Act as either grantor trusts or limited partnerships, rather than under the ’40 Act, which applies to securities. These products function like passive ETFs, engaging in transactions only for capital activity, sponsor fees or portfolio rebalancing in the case of limited partnerships. Currently, only spot bitcoin and ether are approved for use in these structures. Grantor trusts, similar to those used for commodities like gold, are limited to holding a single asset, and investors directly own a proportional share of that asset.
In December 2024, the SEC expanded its approval to include limited partnerships holding both spot bitcoin and ether, such as the Hashdex Nasdaq Crypto Index U.S. ETF (NASDAQ: NCIQ) and the Franklin Crypto Index ETF (NASDAQ: EZPZ). These limited partnerships are structured to accommodate multiple assets, unlike single-asset grantor trusts. Beyond spot products, investors can access exposure to crypto through ’40 Act funds that invest in derivatives based on underlying crypto assets. These derivative-based funds allow for diversified exposure but remain limited to bitcoin, ether, XRP or Solana. The growth of derivative products is seen as a key part of broader financial market innovation, providing regulated avenues for crypto investment while maintaining compliance with existing securities laws.
Looking ahead, crypto asset managers are eager to solve challenges faced by the currently available ’33 Act and ’40 Act crypto fund offerings, such as challenges with investing in the spot ether ETFs since staking activity is not yet approved by the SEC. By investing in these spot ether grantor trusts or limited partnerships, investors are foregoing an estimated staking yield of 4% to 7% that they can otherwise earn through holding ether in a private wallet or investing in private funds. Investors are also limited to exposure in the currently approved spot or derivative products, and must solve through private wallets and private fund investments until the SEC provides further approval and clarity. Lastly, the currently approved products are unable to receive or distribute capital subscriptions and redemptions to authorized participants in-kind as other ETFs currently operate. This causes additional complexities for these products that would not ordinarily occur within an ETF invested in securities that are approved for in-kind subscriptions and redemptions.
A major step forward to solving these challenges lies in the hands of the SEC’s newly created Crypto Task Force. The group seeks to provide clarity on the application of the federal securities laws to the digital asset market and to recommend practical policy measures that aim to foster innovation and protect investors. This task force will play a critical role in drawing clear regulatory lines, distinguishing securities from non-securities, and provide realistic paths to registration, among other objectives. Once achieved, this should give asset managers clarity and confidence in launching additional products to meet investor demand in the digital asset market.
In addition to launching the Crypto Task Force, the SEC has shown an increasing openness to these products, evidenced by recent acknowledgement of the many filings for additional digital asset funds and products holding more than bitcoin and ether — such as Solana, Litecoin, baskets of multiple digital assets in addition to bitcoin and ether, and more — which indicates progress and potentially a promising near future for digital assets within registered products.
There is no shortage of innovation and change on the horizon in the investment company ecosystem, and the change is coming soon. As decisions surrounding the ETF share class and digital asset ETFs are made, the industry will have to be ready to address the challenges ahead, adapt their processes and work together to take on changes in infrastructure. There is always a race to be first, but issuers should expect the due diligence process and operational lift to take some time to implement.
Contact Jack Taylor, Tom Cummings or a member of your service team to discuss this topic further.
Thank you to our panelists for participating in this session with us: Bill Arnold, ETF Director, Investment Manager Services, SEI; Brittany Christensen, SVP, Head of Business Development, Tidal Financial Group; Brett Eichenberger, Market Leader, Registered Funds, Cohen & Co; Alexander Morris, Chief Executive Officer, F/m Investments LLC; Morrison Warren, Partner, Chapman and Cutler LLP; Paul Weisbruch, ETF/Options Sales & Trading, GTS.
In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.