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Article08 Mar 2022

Getting Your Mutual Fund Ready to Enter the ETF Race

The trend of converting mutual funds to ETFs is gathering momentum but what are the things managers should consider before making the switch?

Investor appetite for Exchange-Traded Funds (ETFs) continues to grow at a rapid pace. In the US, the ETF market has experienced an annual growth rate of nearly 20% over the last decade bringing its Assets Under Management (AUM) to more than $7 trillion at the end of 2021, according to ETFGI. The surging popularity of ETFs has not gone unnoticed, and a growing number of asset managers are exploring how to enter the ETF marketplace.

One of the main challenges for asset managers launching ETFs is getting the necessary scale to be successful in the highly competitive ETF market. Converting an existing mutual fund into an ETF is one way firms can get a leg up when entering the ETF market, and several high-profile firms have already taken the plunge. Earlier this year, Dimensional Fund Advisors converted four US. tax-managed mutual funds with a total AUM of $29 billion into active transparent ETFs. It is expected that other mutual funds will eventually follow suit. According to Bloomberg analysis, up to $1 trillion of mutual fund assets, or roughly 10% of the industry’s total AUM, could convert into ETFs within the next 10 years. However, converting a mutual fund into an ETF structure is not straightforward and requires careful planning to manage the operational challenges.

Choosing the Right Path

When embarking on a conversion, the first step is to identify which of your funds are good candidates to become ETFs. A key consideration is whether to launch a transparent or semi-transparent ETF. A transparent ETF must provide details of their holdings on a daily basis, whereas a semi-transparent ETF is only obliged to share their positions once every quarter. Semi-transparent ETFs’ infrequent reporting is designed to shield ETF managers from any potential front-running, making them appealing for active managers. Despite the potential attractiveness of the semi-transparent ETFs, there are some limitations. For example they can only invest in exchange-traded US securities. In addition, operating a semi-transparent ETF requires acquiring a license from one of operators of the Securities and Exchange Commission (SEC) approved models.  As a result of this additional complexity, all the mutual funds that have converted into ETFs to date have chosen to become fully transparent. “So far managers are looking to convert funds into traditional transparent ETFs because there is an established market and they are more familiar to investors,” says Jo-Ellen Yan, Director of ETF Product Development at Citi Securities Services. “By comparison the semi-transparent market is still relatively new and will likely bring additional complexity in both the conversion process, as well as in trying distribute and grow the ETFs.”

Getting Your Ducks in a Row

In order to execute the conversation managers will need to secure a few approvals. To begin, the funds’ board will need to approve the conversion. To do so, they need to be comfortable that the switch to an ETF is in the best interest of the fund and doesn’t negatively impact existing investors. This can sometime be a challenge. “Many fund board members may be unfamiliar with how ETFs operate, so engagement is vital,” notes Yan. “Creating an educational program to help the board understand how ETFs work can be helpful in getting approval.” notes Yang. Finally, managers need to get exemptive relief approval from the SEC. Historically, getting approval from the SEC could be a time consuming process. However, as more funds pursue conversions, the process should become more straightforward.

Handle With Care

Managers need to be as articulate as possible when communicating with their shareholders about what the conversions entails because they will be the most impacted. “Investors are at the heart of the conversion,” says Peggy Vena, Global Head of ETF Services at Citi Securities Services. “Having a proactive shareholder communication plan can help to facilitate a smoother transition and avoid operational issues down the road.” A conversion will impact shareholders in a few keyways. For example, a share-class consolidation may be required as an ETF will typically only have a single share class, as opposed to a mutual fund that often operates multiple share classes. Another potential impact will be resolving the fractional share issue. Unlike mutual funds, ETFs do not usually issue fractional shares; so managers will need to redeem those shares ahead of any conversion.

The biggest challenge in the conversion of a mutual funds is dealing with how ETFs are held by the end investor. Unlike mutual funds, it is not possible for shareholders to invest directly into an ETF because they are traded on the secondary market. Consequently, investor ETF shares are always held in brokerage accounts. In addition, unlike with a mutual fund, the ETF transfer agent must be a member of the Depository Trust and Clearing Corporation. “The ETF transfer agency process is the biggest logistical challenge when converting a mutual fund into an ETF, especially if underlying mutual fund shareholders don’t have brokerage accounts,” explains Vena. “It’s critical that all ETF shares are delivered to the relevant participants ahead of the market opening on conversion date ― a process which needs to be exercised with extraordinary care and diligence.” To ensure this goes well, managers must identify who their direct shareholders are and engage with a brokerage firm to create a straightforward mechanism by which to open accounts or utilize a stock transfer agent to allow investors to continue to hold ETFs in registered form.

Getting the Process Right

While some of the operational requirements that come with mutual fund conversions can be complicated, they are not insurmountable. Given the various intricacies involved in the transition, the process requires time, commitment, and most importantly, planning. With conversions expected to become increasingly ubiquitous, it is vital managers partner with service providers, who have the expertise and resources needed to support these transitions.

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