Adviser converting fund to ETF? Here are some tips for boards

September 14, 2023

By Susan J. Templeton

More than 90% of financial advisors who participated in a recent Financial Planning Association survey said they use or recommend exchange-traded funds, and of those, half said they plan to increase their usage in the next 12 months. The findings of The 2023 Trends in Investing Survey demonstrate that the popularity of ETFs remains high.


The reason for this fundamental industry change is well known and understood. The demand for ETFs by investors and their advisors is due to tax efficiency, transparency, lower operating costs, lower cash drag on performance, and the ability to trade intraday. In a move to capture those investor dollars, a number of fund groups in recent years have launched ETFs and/or converted existing mutual funds into ETFs. For boards overseeing mutual funds, the move to overseeing ETFs through a fund conversion can be challenging and complicated. According to a fund industry legal expert, it’s important for independent directors to understand the intricacies of ETFs—and be confident the adviser does as well. “We see a lot of folks who think they understand ETFs because they ran mutual funds, until they actual get [into] the day-to-day operations,” the expert said.


In addition to the ability to meet investor demand for ETFs, there are less obvious benefits to converting a mutual fund into an ETF. For instance, a mutual fund holding securities with significant embedded gains can convert to an ETF, enabling shareholders to defer the recognition of capital gains. And while ETFs are subject to the same 15% illiquid limitation as mutual funds, if an ETF is trading in-kind with its authorized participants (APs), it is not subject to the same bucketing requirements. Of course, there are cons to eliminating a mutual fund by converting it into an ETF.


Much of the decision-making around converting (or not) will depend on the client base and how and where assets typically are raised for the mutual fund in question.


Challenges to Consider

If the mutual fund is sold through a broker, there are aspects associated with that distribution model that will need to be considered before deciding to convert. There are often a variety of fees associated with mutual funds on which brokers rely and which don’t exist for ETFs, including sales loads, 12b-1 fees, and charges for various classes of shares for certain funds (a fund with multiple share classes will need to consolidate those share classes into one in advance of any transition). For funds like these to be successful once they’re converted to the ETF structure, the adviser must have a plan for retaining and continuing to raise assets.


If the mutual fund is primarily bought and held directly by the investor via a transfer agent, rather than through a third party such as a registered investment advisor or brokerage firm, those investors will be required to set up an account with a brokerage firm to hold their newly converted ETF. Because of this, the fund risks losing investors ahead of or upon conversion to another fund group that can more easily accept their money.


If shareholders of the mutual fund include retirement plan participants and the provider determines the offering of fractional shares is necessary, the new ETF will not be able to be substituted for the original mutual fund. This also can lead to a loss of investors and assets from the fund.


ETFs are required to disclose holdings on a daily basis. If the adviser or the board deems this information proprietary and does not feel such disclosure is in the best interest of the fund, applying for exemptive relief from the Securities and Exchange Commission may be an option, though one that is time-consuming and expensive.


Structuring the Conversion

Once the decision to convert a mutual fund into an ETF is made, most fund groups opt to do so via a merger rather than through a direct conversion or reorganization.


The direct conversion approach involves the organization building an internal shell ETF under Rule 17a-8 and putting in place the supporting back office. The fund prospectus is changed, and managers are spared a proxy vote unless the trust documents or the state in which the fund is registered explicitly require this. The fund board approves the conversion, provided it deems the move to be in the best interest of the shareholders. Once everything is set up and approved, the existing mutual fund is merged into the shell ETF.


Under this approach, the organization is subject to all the rules and regulations required to manage an ETF, including the board’s role of overseeing the process. It can feel to the board members as if they are doing two jobs at once, given the overlap in oversight of and responsibilities to the existing mutual fund and the soon-to-be formed ETF. As an asset transfer, the funds’ track record can be kept intact.


The merger/reorganization method is probably the most cost effective, but least used. Under this approach, the trust agreement and registration statements are amended, and the fund complex is required to put forth a shareholder vote prior to the conversion. A shareholder vote requires a proxy vote solicitation, a time-consuming process that most directors would prefer to avoid. This is mainly why the direct conversion method is preferred.


Typically, this structuring is not taxable to shareholders and, as with the direct conversion, the track record of the fund can be kept intact. 


Board Responsiblities

ETFs have many of the same oversight requirements as open-end mutual funds, but there are additional—and different—board responsibilities directly related to the conversion process and as they transition to, and go forward with, overseeing the ETF structure.


To start, the board will need to approve the plans to convert, including ensuring that the interests of existing shareholders will not be diluted. The board’s initial responsibilities include:


  • authorizing various regulatory filings, including a registration statement and prospectus;
  • approving an amendment to consolidate share classes for those funds that have multiple share classes;
  • devising a plan to communicate with shareholders in advance;
  • determining how redemptions related to the conversion will be handled, especially if there are transaction costs associated with redemptions; and
  • considering the costs of the conversion and whether those costs should be borne directly or indirectly by shareholders.


Additionally, there will be a contract to review regarding the primary exchange on which the ETF will be listed, including considering a designated or lead market maker for the ETF, and the listing exchange may have its own requirements for the board. If there is a non-U.S. component to the ETF, this can add to the risks and potential liabilities for the adviser and is something the board will likely monitor going forward.


Investment Objective, Fund Design

If the proposed ETF’s investment objective is going to be similar to any existing funds, the board will want to understand and consider how the new ETF will impact those mutual fund shareholders and the funds’ asset levels. In many cases the adviser may need to adjust the portfolio in advance of the conversion to be compliant with exemptive relief; therefore, the board will need to understand tax implications for shareholders. Other considerations relate to any size limitations there might be on the ETF, costs, and break-even levels associated with the new ETF.


To understand how well the mutual fund’s investment objective will transfer to an ETF structure and how it is expected to perform once converted, directors may want to start with some questions to the adviser:


  • If the fund tracks an index, does this pose any SEC or limitation issues related to diversification?
  • For an index ETF, will the holdings be optimized and/or weighted differently from the underlying index?
  • How might those differences affect costs in the creation and redemption process?
  • How might those differences affect tracking error?


Boards should understand the process for creating and redeeming ETF creation units and should understand the secondary market and how it is working to benefit ETF investors. The attention should be on how much and how often the fund trades at a premium or discount, the bid-ask spreads, tracking error, and trading volume.


When evaluating contracts with providers, special attention should be given to the distributor and its services in connection with the APs (typically, a large institutional investor/broker-dealer who has entered into an agreement with the ETF to provide the creation basket or cash or both) and market makers. The board will want to know and understand if the APs will be allowed to purchase and redeem creation units in-kind, with cash, or both. They should understand the impact of that decision on dilutive costs and tax consequences and consider requesting ongoing reporting on these transactions.


The board should be aware that international equity ETFs typically have wider spreads than domestic equity ETFs and that those wider spreads are a result of higher transaction costs in the securities and the risks associated with the underlying markets being closed during ETF trading hours.


Finally, boards should remember that a mutual fund-to-ETF conversion can be in the best interest of the current shareholders that they represent, despite the extra work that needs to be put in during the transition process. Even though a variety of approvals are necessary to complete a merger or conversion, it has never been easier to create an ETF or merge/convert a fund to an ETF. The upside includes potential asset growth, meeting investors' needs and demand, and overseeing globally recognized products that can attract positive attention to the fund complex.

Susan J. Templeton serves on the board of Claridges Trust Co. and on the advisory boards of Morningstar Inc. and Seyen Capital. Earlier in her career, she held senior roles at William Blair Funds and The Newton Funds.



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