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. Show 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:
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:
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:
“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) 3https://www.sec.gov/rules/final/2019/33-10695.pdf 4https://www.ecfr.gov/current/title-17/chapter-II/part-270#270.17a-8 5https://www.sec.gov/rules/sro/nysearca/2020/34-88625.pdf Our Current Issue: Q3 2022
What is a conversion privilege in mutual funds?Key Takeaways
Exchange privilege is the opportunity given to mutual fund shareholders to exchange their investment in a fund for another fund within the same fund family.
Can you switch from one mutual fund to another?You can switch mutual funds by selling units of the current mutual fund and purchasing units under a new fund. When you sell any mutual fund units, you will have to pay taxes on short-term or long-term capital gains.
Do mutual funds offer conversion privileges?Conversion Privilege is The right offered to a mutual fund investor, which allows them to move money between different portfolios offered by the same mutual fund family without paying another sales charge.
What is switch in switch out in mutual fund?If you wish to switch within the same mutual fund house, you need to fill a switch form. In that switching form, specify the units to be shifted from the existing mutual fund scheme to the destination fund scheme. The minimum investment amount criteria must be fulfilled for switch-in and switch-out.
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