Should I Convert My Mutual Fund into an ETF?

Over the last few years, many mutual funds have converted into ETFs primarily due to their flexibility and affordability. As an attractive, tax-efficient option, many mutual funds are converting into ETFs to benefit their investors; however, before doing so, it’s important to fully understand what sets ETFs and mutual funds apart. This article explores the similarities and differences between the two, the ETF Rule, and key things to know before converting your fund structure.  

Key Takeaways 

• ETFs are more tax-efficient due to in-kind redemptions and avoidance of taxable gains from appreciated securities. 
• Converting a mutual fund to an ETF involves aligning with the ETF Rule, avoiding the need for complex SEC exemptive relief. However, this shift requires shareholders to adjust to brokerage accounts and the constraints of single ETF share classes. 
• Mutual funds can adopt an ETF share class to existing or newly formed funds, bringing the ETF benefits without converting the entire mutual fund. 

The Similarities and Differences Between ETFs and Mutual Funds 

Mutual funds and ETFs are registered as open-ended management companies under the Investment Company Act of 1940 (1940 Act) and are subject to its rules and regulations. Two key features that differentiate ETFs from mutual funds are how shares are traded and their tax efficiency.  

Distribution Channels 

Mutual fund shares are bought and sold at the net asset value (NAV) per share computed at the end of a trading day through a variety of different distribution channels or directly with the fund. Alternatively, ETF shares are listed on the national security exchanges and trade throughout the day at the market price rather than the ETF’s NAV. Retail investors would buy and sell shares of an ETF through a broker-dealer in the same fashion they would purchase or sell any other stock. This gives an ETF shareholder more liquidity to trade shares throughout the day. 

Generated Gains and Losses 

To satisfy investor redemption requests, mutual funds may often need to sell investments. Fund managers use the proceeds from the sale of assets to fulfill investor requests, and any realized gains or losses are included in the fund’s taxable income. If the mutual fund is in an overall gain position at the end of its fiscal year, the fund is required to make a distribution to shareholders on the ex-date. Owners of the fund receive Form 1099 that reports their annual taxable income inclusions and the tax character of distributions received. Because of an ETF’s unique structure, ETF redemptions are generally made in-kind and thus do not generate any gains that would trigger required distributions to investors. 

Appreciated Securities  

Mutual funds and ETFs typically elect to be taxed as regulated investment companies (RICs) under Subchapter M of the Internal Revenue Code. Funds that make the RIC election can avoid corporate-level taxes, provided they pass through to shareholders at least 90% of the fund’s investment company taxable income and long-term capital gains, and comply with the regulations outlined in Subchapter M. The significant difference between mutual funds and ETFs is that ETFs use in-kind receipt and distribution with authorized participants (APs). This process allows an ETF to avoid selling appreciated securities, which generate capital gains. A mutual fund holding securities with significant unrealized gains could be a prime candidate for conversion, thus allowing shareholders to defer recognition of capital gains that would otherwise be included in taxable income when sold to satisfy redemptions. It should be noted that this difference would benefit retail investors holding assets in their own accounts. If an investor’s mutual fund or ETF securities are held in a tax-deferred account, such as an IRA or 401(k), the deferral of gains would be moot. 

What Is the ETF Rule? 

The ETF Rule, Rule 6c-11, has helped drive new ETF launches over the past several years, as funds no longer needed to obtain exemptive relief before launching as ETFs. Rooted in guiding exemptive relief conditions from the Securities and Exchange Commission (SEC), the ETF Rule has a variety of conditions that cover:  

Daily disclosure of portfolio holdings 

Website disclosure regarding premium, discount, and bid-ask spread information 

Written policies on basket construction and the process of accepting baskets 

With the ETF Rule, there are no longer regulatory roadblocks when converting the mutual fund. Previously, fund sponsors would have had to seek specialized exemptive order relief from the SEC to allow conversions to occur without the use of APs and without the creation of unit aggregations of shares (e.g., 25,000 or 50,000 shares in a creation unit).  

The ETF Rule exempts all mergers and reorganizations from its requirements for AP participation in all ETF share transactions where all share transactions directly with the ETF occur in creation units whose size is fixed in the ETF’s prospectus. This exemption enables the conversion of mutual funds into ETFs without seeking SEC exemptive relief in advance. If ETFs are not meeting the Rule requirements, such as non-transparent and semi-transparent ETFs, they would still need to apply to the SEC for exemptive relief. 

Transforming a Mutual Fund into an ETF 

The industry uses the term ‘conversion’ to describe a mutual fund reorganizing into an ETF structure, but there has not been any direct conversions through amendments to the mutual fund trust agreement and registration statements. Even though it may be the most cost-effective approach to accomplishing the goal of converting to an ETF, the fact that a direct approach would most likely require a shareholder vote before the conversion is most likely why this path hasn’t been taken to date. 

A shareholder vote would require a proxy solicitation and potentially a lengthy SEC comment process, both of which could increase costs and delay the conversion process. 

In most cases, the preferred reorganization scenario is to form a new affiliated ETF entity and, under Rule 17a-8, merge the existing mutual fund with the newly created ETF. The mutual fund’s historical performance could still be used for the ETF, since the merger would be treated as an asset transfer. 

Under either conversion methodology, the mutual fund board will need to approve the conversion and determine whether it is in the shareholders’ best interest. The following attributes should be persuasive enough to satisfy the board as to the merits of transitioning to an ETF structure: 

• Tax efficiencies obtained as described above would be beneficial to most shareholders. 
• The ability to trade shares intra-day versus at the end of each day based upon the market price of the ETF. 
• ETFs typically have lower costs than mutual funds because they incur lower transaction costs due to fewer investment transactions, lack 12b-1 fees, have no state registration fees, and incur lower transfer agency and shareholder servicing costs. 
• ETFs generally do not need to maintain a cash balance, so they can achieve better returns by being fully invested. 

What to Know Before Converting Your Fund Structure 

With any contemplated transaction, there are always negative aspects to consider. A mutual fund will need to take the following into consideration when deciding whether to convert to an ETF: 

• ETFs typically do not issue fractional shares, so any fractional shares held by mutual fund shareholders at the time of the conversion would need to be redeemed and potentially be subject to taxation. 
• Many mutual fund shareholders hold their shares with the fund’s transfer agent. Since ETF shares are held through brokerage accounts, all mutual fund shareholders will need to establish accounts with a Depository Trust and Clearing Corporation (DTCC) member broker to keep the ETF shares and buy or sell them after the conversion. 
• ETFs only offer one single class of shares. When converting the various share classes into ETF shares, the mutual fund will need to issue ETF shares based on each share’s net asset value, rather than a one-for-one exchange. It will also need to determine which share class aligns with the ETF share for reporting purposes, how to convert processes to align with ETF processes, market makers, and APs, and update compliance policies.  
• ETFs are traded on an exchange. ETFs operating under the ETF Rule would satisfy the generic listing standards previously approved by the SEC staff. ETFs not qualifying under the generic listing standards would need to apply for approval with the specific exchange and the SEC’s Division of Trading and Markets. 

There has been a steady climb in the number of conversions in recent years from 20 conversions in 2022 to 55 in 2024 and 60 in 2025.  

ETF Share Class 

A new exciting development is the emergence of mutual funds adding an ETF share class to existing or newly formed funds to reap the benefits an ETF brings without converting the entire mutual fund. An ETF share class would maintain the key advantages of an ETF as described above, such as intraday trading on an exchange and its tax efficiencies.  

Fund sponsors would need to obtain exemptive relief from the SEC in order to utilize an ETF share class in its mutual fund. Up until 2023, Vanguard held a patent on an ETF share class in index tracking mutual funds. Since the expiration of the patent, over 80 mutual fund sponsors have applied for exemptive relief to offer mutual funds with an ETF share class. Dimensional Fund Advisors has been the first fund sponsor to recently receive ETF share class exemptive relief from the SEC post the expiration of the Vanguard patent. The SEC staff is encouraging other applicants to file or amend their applications to be substantially similar to the Dimensional filing to help expediate the approval process. 

What is additionally noteworthy is the Dimensional exemptive relief is not restricted to index funds and can be utilized by actively managed funds as well. 

Going Forward with ETFs 

Are you looking to transform your mutual fund structure? Converting to an ETF or applying to add an ETF share class might be a strategic move that aligns your portfolio with investor expectations and long-term business goals. With lower operating costs, enhanced tax efficiency, and greater trading flexibility, ETFs offer a market-friendly alternative that continues to gain popularity across the industry.  

EisnerAmper’s team is here to guide you on your conversion journey, prioritizing compliance, transparency, and communication. Learn how we can support your strategy and contribute to your long-term success. Contact us below.