The ETF industry continues its rapid pace of growth in both issuances and AUM. One of the trends that is currently fueling this is the conversion of mutual funds to ETFs. Why is this happening? Traditional mutual fund asset managers do not want to be left behind in this asset grab and need to diversify their product offering to appeal to a broader range of investors, basically becoming wrapper agnostic with their product strategies. The evolution and acceptance of actively managed ETFs and the ease of launching through the ETF Rule (6c-11) is expanding the ways ETFs can access mutual fund assets.
Mutual fund managers entering the ETF space for the first time have numerous decisions to make, including how best to grow the proposed ETFs’ AUM to at least the break-even level. Successful launches come with a committed manager ready to dedicate time and capital to the program, mostly through large amounts of seed capital either from the manager’s coffers or from the assets of existing mutual fund, private fund or SMA clients. Mutual fund managers can enter the ETF business by creating new ETFs, buying an existing ETF complex or tapping into mutual fund assets through a conversion or creating an ETF class of the mutual fund. For the purpose of this piece, we focus on the latter options because they each offer the mutual fund manager the advantages of instant scale and a potentially multi-year track record critical for growing ETFs. We will discuss both the direct conversion of a mutual fund into an ETF and the newly available option of adding a “Vanguard-like” share-class to the mutual fund.
The U.S. ETF industry is approaching $6 trillion in assets and despite the popularity of the ETF structure, it still trails the $27 trillion mutual funds industry. The gap is expected to continue to narrow as inflows continue to favor ETFs, $614 billion in 2022 versus $536 billion for mutual funds. The current trend in the conversion of mutual funds to ETFs is accelerating this narrowing gap. According to Aniket Ullal of the CFRA in a January 2023 ETF.com article, there were $42 billion in mutual fund transfers to ETFs in 2022. This number is going to grow as financial intermediary users of the registered fund product recognize the inherent advantages of the ETF over the mutual fund, most importantly tax savings and intraday trading for their clients and customers. These inherent advantages have begun to take a toll on traditional mutual fund managers, and many have realized that offering ETFs is the most practical way to compete for new assets and new investors. Dimensional Funds, Capital Group and JPMorgan are amongst the larger fund managers to convert significant amount of AUM to ETFs and make a commitment to the ETF industry.
Dual Mutual Fund/ETF Class Products
Vanguard is the only fund complex that currently offers dual mutual fund/ETF class products. Not surprisingly given its history of innovation in the public fund industry, Vanguard devised how to structure, operate and offer a single investment company with a mutual fund and ETF class approximately 10 years ago. The firm protected its innovation with a patent that expires in May, 2023 and has expressed a willingness to license its technology. Importantly, Vanguard needed and obtained an SEC exemptive order permitting this unique structure. In addition, the exemptive order permitted only index funds with dual mutual fund/ETF classes.
In anticipation of the Vanguard patent’s expiration, Perpetual Group recently filed an exemptive application with the SEC seeking to offer funds with dual mutual fund/ETF classes. Unlike the Vanguard exemptive order, Perpetual Group seeks relief from the SEC to offer both actively managed and index funds issuing dual mutual fund/ETF class shares.
In our view, it is early in the game for mutual fund providers seeking to enter the ETF business with scale to consider the option of adding an ETF class to its existing mutual funds. The primary obstacle will be the fact that each mutual fund provider will have to apply for and obtain its own exemptive order and the SEC has not issued such an order in over 20 years. Much has changed since 2000 including the SEC Chairman and much of the staff in its Division of Investment Management, the Division responsible for issuing such orders. Even though precedent exists in the form of the Vanguard exemptive order, it is our understanding that the SEC will only issue a second such order after it is presented with conditions from the applying fund complex successfully addressing and mitigating the conflicts of interest among a fund’s mutual fund and ETF share classes. For instance, the SEC presumably will have to be satisfied that mutual fund shareholders under a combined structure do not unfairly reap the taxation benefits from the ETF create-redeem process at the expense of ETF shareholders. Because of the uncertainty of the timeframe of such approval, mutual fund complexes considering entering the ETF business by leveraging their mutual fund assets therefore may want to make adding an ETF class to their funds the Plan option B, while making conversion their Plan A option.
Mutual Fund to ETF Conversions
Conversion remains the clearest path forward for a mutual fund complex to unlock its AUM as a means of seeding new ETFs. The industry has solved the initial operational issues including moving the shares of a mutual fund shareholder maintained at the fund’s transfer agent to an account at the shareholder’s broker-dealer. On the regulatory front, a key decision by the SEC to not require mutual fund shareholders to approve a conversion to an ETF significantly reduces the cost of the conversion as well as the number of days it takes to effect the conversion.
Nevertheless, there are benefits, challenges and internal processes to navigate prior to giving a “green light” to the conversion. The decision tree for a go/no go decision need not be lengthy but it does require careful consideration and planning as the ultimate decision will have a significant impact on an asset manager’s business.
Listing the benefits of conversion is a logical first step. These include the ability to import and use each mutual fund’s track record, transfer mutual fund AUM to gain scale, offer intraday and tax benefits for their shareholder clients, potentially lower costs of operating registered funds (e.g., significantly lower transfer agent costs) and increase access to its financial products (i.e., ETF shares are one click away on the Internet).
After placing these positives on one side of the scale, the asset manager must place the negatives on the other side of the scale. Negatives (or in some cases challenges) include adapting to new methods of distributions, establishing relationships with new distribution partners, marketing without the 12b-1 fees (and sales loads) that juice the distribution of it mutual fund shares, realizing that 401K platforms are geared toward mutual fund options, understanding that ETF tax advantages do not help 401K and IRA accounts, revealing the “secret sauce” when using the ETF structure (unless paying for a non-transparent structure) and having to invest significant money and other resources in educating its employees or hiring new employees to master the capital markets (or paying for a sub-adviser to take the lead on creations, redemptions and rebalances).
The decision by an asset manager to access its captive mutual fund AUM by adding an ETF class to its mutual funds or converting the mutual funds’ AUM into ETFs will be seismic. Given trends in the registered fund industry, it should not be put off. However, the decision is highly idiosyncratic to a given mutual fund asset manager with many more variables to consider than those discussed herein. Fortunately, the ETF ecosystem continues to be remarkably collaborative, a spirit in large part responsible for ETFs garnering trillions of dollars of AUM and closing the gap on mutual funds in terms of assets. A mutual fund asset manager can tap into a variety of consultants and service providers that live in this ecosystem for assistance with weighing the pros and cons of conversion and how to plan for and effect such conversion if a “go” decision is reached.