• Simon Zais and Max Mauro
  • Published: 12 October 2021

Mutual funds and exchange traded funds (ETFs) have coexisted since the introduction of ETFs in 1993, providing discrete benefits and appealing to end investors and financial intermediaries for varying reasons. But recently, notable mutual fund to ETF conversion activity, driven by regulatory tailwinds and changing investor considerations, may make mutual fund managers take a closer look at the concept of converting. While we are likely not witnessing the imminent demise of the mutual fund industry, the landscape has certainly changed and requires re-evaluation. 

By considering converting existing open-ended mutual funds to ETFs, fund companies can find themselves pitching to more receptive clients, playing under newly defined rules, and tapping into resilient and encouraging fund flow trends. 

Although not the first to make the move, in June, dimensional fund advisors converted four funds totalling nearly $29B in assets, instantly becoming a top ETF issuer by volume. This dwarfs the size of previous conversions and shows that rather than being simply a niche solution, conversion can work for large, active, high-visibility funds. [1] 

Client demand for the benefits of ETFs provides strong support to companies looking to make a similar journey. Compared to mutual funds, which distribute both long- and short-term capital gains each year potentially forcing clients into an unwanted tax situation, the ETF wrapper allows for the retention of those gains and deferral of their realization. ETFs also sport the benefits of intra-day trading, optionality, and immediate marginability. ETFs (and closed-ended funds) also trade at a discount or premium to the value of the assets in the fund, giving clients and advisors an extra opportunity to potentially capture value. Additionally, the fee structure is typically more transparent and often (although obviously not always) lower than comparable mutual funds.  

From the managers’ point of view, those actively running money have long flocked to mutual funds because of rules surrounding position disclosure. Those managers may still find that regime beneficial, but the SEC has recently moved to ease that deterrent with the adoption of the “ETF Rule,” allowing certain ETF managers to play by friendlier disclosure rules without first requesting an exemption [2]. Furthermore, rule 6c-11 allows ETF managers more flexibility to operate within a master-feeder structure and hold investments in pockets. Combined with the success of recent transitions, this regulation evolution warrants serious consideration by mutual fund managers on the potential benefits of a transition. 

This is not to say there are no benefits to directing money through a mutual fund, though. Some managers, whether because of strategy or operational constraints, may prefer the ability to close to new investment—a feature not available to ETF issuers who must mint new shares when the market demands them. This new issuance can force active managers, as their AUM grows, to pursue second-tier investment strategies as their best ideas are diluted away. The operational burden of working with various authorized participants and market makers can prove onerous to smaller players, when compared to the straight-forward share issuance process of mutual funds. The flip side of that is the benefit of ETFs being able to process redemptions in-kind, as opposed to mutual funds being forced to liquidate at an inopportune time and creating yet another taxable event. [3] 

In addition to the SEC and obtaining their seal of approval, there are three main groups of stakeholders for mutual fund managers to consider once a decision to convert has been made: the shareholders, the board of directors, and service providers. While legal consul needs to be engaged and this list is far from exhaustive, a brief summary of those concerns would include whether there needs to be a shareholder vote on the conversion, and how clients holding shares outside of brokerage accounts—either in qualified plan accounts or held directly at the fund company—could be affected by and remedied after the conversion. Directors may have their roles or responsibilities amended by a conversion, and will ultimately have to sign off on any action taken. 

Finally, as mentioned above, relationships will have to be established and staked with authorized participants and market makers to enact the ETF mechanisms. There are also barns to be raised with exchanges around listing, and with custodian banks surrounding corporate actions considerations.   

Fund flows tell the story. In 2020, over $500bn found its way into ETFs. On the contrary, mutual funds attritted over $280bn during that same stretch. [4] Investors are already making the switch, and it’s time for managers to plan their next move. Is that move innovation? Disruption? Growth? Or is it stoic antagonism to industry sea-change?