Converting from mutual funds to ETFs offers an enticing opportunity for fund managers to appeal to investors’ evolving preferences. However, it’s a step that demands careful thought and preparation.

When considering a mutual fund to ETF conversion, fund managers need to evaluate all pertinent factors, including their investment strategy, fee structures, tax implications and market conditions.

Investor preferences

The primary incentive for converting mutual funds into ETFs lies in how the ETF structure addresses investor preferences for:

  • Increased accessibility: ETFs can be traded throughout the day at market prices, making them highly accessible to a wide range of investors. This is distinct from mutual funds, which can only be traded at the day’s end at the net asset value price.
  • Greater transparency: ETFs disclose their holdings daily, providing investors with a clear view of where their money is invested. This level of transparency surpasses that of mutual funds, which generally disclose their holdings quarterly or semi-annually.
  • Improved intraday liquidity: Despite some limitations with daily liquidity and arbitrage opportunities, the structure of ETFs typically offers superior intraday liquidity than mutual funds. Investors can trade ETFs like individual stocks, which adds a layer of flexibility not seen with mutual funds.
  • Improved tax efficiency: Generally the ETF manages the creation and redemption of shares (generally) by dealing in‐kind, it will not incur gains and losses from portfolio transactions that are incurred in traditional mutual funds to meet redemption requests from other shareholders.

But meeting these investor desires by no means guarantees success. With thousands of ETFs now listed in the U.S., effective promotion and distribution strategies are indispensable. The ideal scenario is to convert a product that already has traction.

Also, plan how you’ll reach a broader audience. Understand the lay of the land on platform listings. Although platform fees may be low or non-existent, that doesn’t necessarily mean you’ll be listed. You may also want to consider your advertising and marketing strategy. Digital marketing can provide an efficient, cost-effective channel to increase audience reach, and the use of analytics, digital media, and personalized messaging can greatly enhance a fund’s visibility post-conversion.

Other critical factors for mutual fund to ETF conversions

When contemplating a shift from a mutual fund to an ETF, there are several factors fund managers must consider, including:

  • Cost efficiency: While lower advisory fees of ETFs might be appealing, significant cost savings can also stem from reduced platform fees and other related costs. ETFs, unlike mutual funds, typically have very low or no platform fees.
  • Performance: The success of a mutual fund conversion to an ETF relies heavily on strong volume activity in the ETF. Investors (and their financial advisors) look for evidence of robust performance before conversion. Most are also leery of investing in ETFs with low daily trading volume.
  • Branding: For smaller fund managers striving to establish themselves in the marketplace, a strong brand and market recognition are essential. Converting to an ETF can serve either as a means to offer an existing strategy through a new vehicle, thus attracting new assets, or as a defensive move to ensure market presence as the landscape continues to shift towards ETFs.
  • Legal and tax considerations: The conversion process comes with potential legal and tax ramifications, including the management of tax-loss harvesting and the implications of eliminating 12b-1 fees (and how to handle any unspent 12b-1 fees). Legal fees can be a significant part of the conversion costs. The tax implications, whether the reorganization can be treated as tax-free or not, need thorough case-by-case consideration.
  • Broker and Authorized Participant (AP) partners: An investment manager needs to be comfortable with daily disclosure of holdings. Less understood is the process for creating a custom basket for the ETF. Not all investment strategies allow for this, and it’s crucial to assess how quickly and easily the authorized participant and the broker can hedge their investment by buying those securities.

Seek input from your partners

In conclusion, converting mutual funds to ETFs can offer substantial benefits, such as improved transparency, tax efficiency, and trading flexibility. However, the process is complex and requires careful due diligence and strategic planning. Fund managers should not shy away from seeking expert advice during this process.

At UMB, we provide a consultative approach, leveraging our industry experience to guide you in making informed decisions.

Learn more about UMB Fund Services and how we can support your firm’s registered and alternative investment fund servicing needs, or contact us to be connected with a fund services team member.