Vanguard's ETF Patent

In mid-2001, Vanguard obtained a patent protecting its method for creating ETFs. Today, Vanguard remains the only fund company able to use this low-cost structure. Investors can transfer from Vanguard mutual fund shares into similar ETF shares without triggering a tax event. Gross expenses for fund owners are the same whether they own a Vanguard ETF or Vanguard mutual fund. Vanguard offers ETFs as a separate share class of its existing mutual funds; economies of scale keep costs low. By piggybacking on established mutual funds, Vanguard was able to ramp up its ETFs without worrying about how many dollars went into the ETF instead of the mutual fund.

State Street is able to connect existing mutual funds to their ETFs using a “master-feeder” design. The ETF channels investor money into existing mutual funds and holds only shares in the channeled funds. With this structure, each feeder ETF bears its own administrative costs and pro rata share of management fees. Investors cannot convert shares from one feeder fund to another.

Other fund families are trying the master fund approach or are structuring their ETF as a stand-alone fund resembling, but not connected to, a traditional mutual fund.