Is a Mutual Fund Conversion to ETFs Right for You?

Hosted by Douglas M. Yones, head of exchange traded products at the New York Stock Exchange, the webcast included guests Peter Shea, partner at K&L Gates; Ryan Sullivan, head of U.S. ETF services at Brown Brothers Harriman; and Mo Sparks, director of exchange traded products at the New York Stock Exchange.

ETFs have become enormously popular with investors, bringing in $1 trillion of inflows in 2021, and with the passage of the ETF Rule 6c-11 in 2019 and its being enacted last year, there has been a revolutionary approach to conversion into ETFs, said Shea.

“That rule clearly contemplates that you’ll engage in reorganizations, mergers, conversions of other products into ETFs, and for those transactions you are exempt from needing to deal through an Authorized Participant, and you’re exempt from dealing in creation unit aggregations of shares,” Shea explained.

It has made the mutual fund conversion process much easier, particularly with major exchanges creating generic listing rules for these conversion funds, rules that have requirements that are increasingly easing. Another enticing possibility was the creation of semi-transparent ETF options that allow for the daily holdings to be concealed and a proxy basket used instead as an example of the holdings of the fund; this has been of particular interest for many mutual fund managers.

“Even though we’re a couple decades into the ETF lifecycle, that growth (speaking on the flows into ETFs last year) is accelerating, so that is a massive tailwind now for managers looking at their mutual fund line-up, and as Doug touched on it, some of them are already in the ETF space and looking to retool those mutual funds that may have more upside as an ETF vehicle,” said Sullivan.

There are several benefits to converting a mutual fund to an ETF; wirehouse and independent brokers generally want to see an established track record and AUM minimums, which will have been well established by the mutual fund. From a distribution perspective, when it comes to converting mutual fund strategies into ETFs, a conversion eliminates the need to choose between a mutual fund and an ETF that share a “cloned” strategy when listing them on a platform, explained Sullivan.

Sullivan explained that there are generally three different channels that clients fit into when considering a mutual fund conversion: “You’ve got the old legacy, kind of direct shareholder and the retail base as one channel, you’ve got your intermediaries and your broker-dealers in a second channel, and then you’ve got your institutional investors in the third.”

Addressing how each client channel will be impacted by conversion requires separate considerations and planning. How the internal teams and support will change to accommodate an ETF vehicle, which requires tracking of things such as liquidity and trading volume, is another conversation that should be had with the intermediary clients.

“We’re seeing a growing interest amongst mutual fund sponsors who have multi-class structures. A lot of the early conversions were very simplistic class structures,” said Shea. “The big worry is that if you have a class that’s paying sales loads to a brokerage channel, will that broker dump all the shares as soon as you announce conversions because they’re going to be cut off from their sales loads?”

While it’s something that can be avoided, and Shea explained that there is an incentive to keeping them involved on the ETF side, it is vital that those considering mutual fund conversion have these kinds of conversations as early as possible with their intermediary clients.

Also discussed are tax benefits and fee structures, share class merging, operational benefits and needs for ETFs, the conversion of SMAs, and questions to ask when entering into the ETF industry.