Mutual fund directors and investment advisers digest

There is no shortage of reasons to join the ETF race, but for those with no existing ETF products there will be regulatory, accounting, reporting, tax, and operational factors to consider in executing a new ETF strategy. If the choice is to launch a new ETF, one key difference between a mutual fund and ETF relates to disclosure of portfolio holdings on a daily basis. A decision will likely need to be made upfront on whether you want to shield your ETF portfolio holdings through the semi-transparent active wrapper, which will require SEC exemptive relief.

Selection of third-party service providers to serve ETFs will likely be a critical part of the launch decision and process, including the distributor, custodian, transfer agent, Authorized Participants (Aps), and law and audit firms. One key area that will likely take time to get right is the basket creation and redemption process and is consistently highlight by investment advisers as one of the most time intensive processes in launching an ETF. A fresh look at compliance processes will also be warranted as some changes to a fund’s policies will need to be evaluated in launching an ETF. Experience with ETFs for middle-office settlements, back-office interactions, and front-office support teams primarily to do with the basket process will be key to driving success.

Since March 2021, more than $60 billion in mutual funds have converted to ETFs. The first firm to complete a conversion was Guinness Atkinson in 2021. Since then, JPMorgan, Franklin Templeton, Fidelity, and Dimensional have converted mutual funds, with others planned for 2024. The conversion path has a number of advantages, including the ability to retain the fund’s performance track record and brand recognition, as well as less cash drift, lower operational costs, and more tax efficiency than a mutual fund.

There are, however, some potential challenges to consider, including the fact that mutual funds that are widely used in 401(k) plans may not be a good fit for an ETF conversion, due to plan recordkeeper limitations associated with intraday trading and fractional shares. Unlike mutual funds, ETFs do not usually issue fractional shares; therefore, managers will need to redeem those shares ahead of any conversion. Also, it’s not possible for shareholders to invest directly into an ETF because they are traded on the secondary market. ETF shares are always held in brokerage accounts. This is a logistical challenge when converting a mutual fund to an ETF as not all shareholders have brokerage accounts. A fund sponsor would need to ensure these converted shares are transferred to an investor’s brokerage account before trading begins.

Launching an ETF as a share class requires filing an application with the SEC and receiving approval. Since the patent expiry in May 2023, several investment managers including Australia’s PGIA and US firms Dimensional, Morgan Stanley and Fidelity have applied to the SEC to establish similar ETF share class structures for their existing passively managed mutual funds. Additionally, it should be noted that to date, the SEC has not approved ETF share classes for actively managed ETFs and has not indicated a willingness to approve applications for ETF share classes on actively managed mutual funds in the future. Thus, the success of this path depends on positive regulatory action.

However, the benefits of ETFs as a share class of a mutual fund might make the wait worthwhile and lucrative.