Should I Convert My Mutual Fund into an ETF?
July 13, 2022
Following the previous article Will ETFs Continue Their Surge in 2022?, which discussed the tremendous growth in the exchange traded funds (ETF) space -- with some coming at the expense of mutual funds -- many mutual funds are now converting into ETFs, a trend the industry has seen since last year.
To name a couple of examples, in March 2021 Guinness Atkinson Funds converted two dividend focused mutual funds into ETFs and in June 2021 Dimensional Fund Advisors converted four funds worth $30 billion.1 More recently in January 2022, JPMorgan converted four funds with combined assets of $8.7 Billion.2 There have been other fund groups performing conversions to ETFs as well and the expectation is that we will see further conversions in 2022 and beyond.
“We view the primary driver for conversion to be the delivery channel and marketability of ETFs,” said Kip Meadows, founder and CEO of The Nottingham Company, a fund administrator who has converted mutual funds into ETFs since last year.
“Mutual fund platforms have remained expensive, with the platforms (brokerage firms holding client accounts) charging the funds a percentage of assets held by the brokerage firms on behalf of their client accounts. These fees must be paid out of the investment advisory fee or 12b-1 marketing distribution fees, keeping mutual fund expense ratios higher than they might be otherwise.” he added. “The platforms also often charge ‘transaction fees’ for the mutual fund trades, where those same brokerages have very low or no trading costs for buying stocks. ETFs trade like stocks, so those same transaction ‘bargains’ are passed on.”
As a quick refresher, both mutual funds and ETFs are registered as open-ended management companies under the Investment Company Act of 1940 (1940 Act) and are subject to the rules and regulations under the 1940 Act. Two of the more significant features that differentiate ETFs from mutual funds are how shares are transacted and the tax efficiencies of ETF vehicles:
- 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 national security exchanges and trade throughout the day at the market price versus the NAV of the ETF. 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.
- To satisfy investor redemption requests, mutual funds may often need to sell investments. The monies generated from the sale of assets are used by fund managers 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 the fund’s fiscal year, the fund is required to make a distribution to shareholders owning the fund on the ex-date. Owners of the fund are given a Form 1099 disclosing their annual taxable income inclusions and the tax character of distributions received. In contrast, due to an ETF’s unique structure, ETF redemptions are generally made in-kind, and thus do not generate any gains that will trigger a required distribution to investors.
Both mutual funds and ETFs typically elect to be taxed at regulated investment company (RIC) status 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 adhere to various regulations set forth in Subchapter M. The major difference between mutual funds and ETFs is an ETF’s use of receiving and distributing in-kind securities with authorized participants (APs). This process allows an ETF to avoid selling appreciated securities which generate capital gains. A mutual fund holding securities with a significant amount of unrealized gains could be a prime candidate to convert to an ETF, thus allowing shareholders to defer the 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 be beneficial to 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 point.
Rule 6c-11 (the ETF Rule)3 helped propel new ETF launches over the last several years as funds no longer needed to obtain exemptive relief prior to launching as an ETF. The ETF Rule has a variety of conditions that were, in many cases, adapted from prior SEC exemptive relief conditions. The ETF Rule’s conditions cover, for instance, daily disclosure of portfolio holdings and disclosure on its website regarding premium, discount, and bid-ask spread information, as well as written policies and procedures regarding basket construction and the process of accepting baskets.
In addition, the ETF Rule also expressly facilitates mutual fund to ETF conversions. “With the advent of the ETF Rule, there are no regulatory roadblocks to converting a mutual fund to an ETF,” stated Peter Shea, a partner and co-head of the ETF Practice at K&L Gates LLP in New York. Before the ETF Rule, fund sponsors would have had to seek specialized exemptive order relief from the SEC to allow conversions to occur without the utilization of APs and creation unit aggregations of share (e.g., 25,000 or 50,000 shares in a creation unit). “No such specialized relief orders had ever been issued by the SEC to permit these types of conversions, which makes the ETF Rule that became effective in December 2019 so important,” Shea added.
All mergers and reorganizations are exempted by the ETF Rule from its requirements for AP participation in all ETF share transactions and that all share transactions directly with the ETF occur in creation units whose size are fixed in the ETF’s prospectus. This exemption from the ETF Rule makes possible the conversion of mutual funds into ETFs without having to seek out exemptive relief from the SEC in advance. For ETFs not meeting the requirements under the ETF Rule, such as non-transparent and semi-transparent ETFs, they would still need to apply with the SEC for exemptive relief.
The industry uses the term ‘conversion’ when a mutual fund reorganizes into an ETF structure, however we have not seen any actual direct conversions through amendments to the mutual funds 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 prior to the conversion is most likely why this path hasn’t been taken to date.
A shareholder vote would require a proxy vote solicitation and potentially a long SEC comment process, both of which could add to the cost and delay the conversion process.
“If there is one pitfall to avoid in this conversion process, it is the need to avoid a shareholder vote on the reorganization into an ETF itself,” Shea said. “Depending on the charter documents of the mutual fund, most ETF conversions should be able to avoid the need for a shareholder vote by reliance on 1940 Act Rule 17a-8 that allows affiliated funds to merge without shareholder vote. A manager may still need to seek shareholder approval due to changes in the fund’s investment advisory agreement caused by the merger, but that is technically not a vote about the merger itself.”4
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 historical performance could still be utilized for the ETF, since the merger would be considered an asset transfer.
Under either conversion methodology, the mutual fund’s board will need to approve the conversion and determine whether it is in the best interest of the fund’s shareholders. 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 extremely 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 since they incur lower transaction costs due to the reduced number of investment transactions, lack 12b-1 fees, have no state registration fees and have lower transfer agency and shareholder servicing costs.
- ETFs generally do not need to maintain a cash balance so there is opportunity for better returns since their portfolio can be fully invested.
With any contemplated transaction there are always negative aspects to consider. A mutual fund will need to take the following under 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 hold the ETF shares and to buy or sell shares after the conversion.
- Many mutual funds offer multiple classes of shares, while ETFs will 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 upon the net asset value of each share class versus just a one-for-one exchange. The mutual fund will also need to determine which share class most closely resembles the new ETF share class structure for purposes of carrying forward the performance track record of the mutual fund. A mutual fund will need to convert its current processes to the ETF creation and redemption process and enter into agreements with market makers and APs. A mutual fund would need to update its compliance policies and procedures to adhere to the new ETF structure. It would be imperative that these are all in place by day one of the conversion in order for the ETF to be operational.
- ETFs are traded on an exchange. ETFs operating under the ETF Rule would satisfy the generic listing standards previously approved by the SEC staff.5 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.
“A conversion may need shareholder approval or other support,” said Keri Riemer, a partner at K&L Gates LLP. “ETFs may not be the preferred investment vehicle for certain mutual fund shareholders. In light of this, advisors may want to consider the mutual fund’s investor base and potential roadblocks with obtaining shareholder approval and support before pursuing a conversion.”
Now that numerous mutual funds have blazed the conversion trail for others to follow and the SEC has not shown any reluctance to prevent any of the previous conversions to ETFs it stands to reason that more conversions will follow in the near future.
1CNBC ETF Edge “Dimensional just converted $30 billion worth of mutual funds to ETFs. What it could mean for the industry.”Dimensional converts 4 key mutual funds to ETFs. Co-CEO unpacks move (cnbc.com)
2Barron’s “4 JPMorgan Funds Approve Conversion to ETFs. The Industry Is Changing.” 4 JPMorgan Funds Approve Conversion to ETFs. The Industry Is Changing. | Barron's (barrons.com)
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