The In and Outs of ETF Conversions

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. A number of asset managers have announced that they plan to convert some of their mutual funds into exchange-traded funds. Joining me today to discuss the topic is Ben Johnson. Ben's Morningstar's director of global ETF research. Hi, Ben. Thanks for being here today.

Ben Johnson: Thanks for having me, Susan.

Dziubinski: What are some advantages of conversions for fundholders?

Johnson: Many of the advantages of converting a mutual fund to an ETF are synonymous with the advantages of the ETF wrapper. It's all about where these funds will ultimately land, the packaging, the form that they'll ultimately take. And I would argue that chief amongst those is the relative tax efficiency of the ETF packaging versus a mutual fund packaging, because ETFs have the ability to regularly send securities out of their portfolios on an in-kind basis, so they can offload stocks and bonds whole directly to a third party, as opposed to having to liquidate them to either sell down positions or meet redemption requests. They avoid unlocking capital gains distributions, which have become very frequent, and in some cases, very large in magnitude within the realm of open-ended mutual funds in recent years. That's a big benefit that would arise from a mutual fund to ETF conversion.

There are other benefits as well. The ETF wrapper in many ways is just more cost efficient than the mutual fund wrapper. So, notably within ETFs' expense ratios, rarely do you see line items that are dedicated to compensating third parties for things like marketing or distribution. Shareholder recordkeeping costs are lower. So, there's the potential for expense ratios to come down a bit as funds pass through this conversion process.

Lastly, transaction costs are likely going to be less because many ETFs trade commission-free across a large number of platforms, which has been a big development in recent years. Meanwhile, many mutual fund investors are still paying commissions as they transact in their mutual funds that they're investing in today. This is a key point of appeal, I think, to the advisor market in particular, where they're making many transactions across a large number of client accounts in any given day and would much prefer to be able to save that money and allow it to compound to their client's benefit.

These are all synonymous, again, with the benefits that we know well about the ETF vehicle more generally. They're kind of beckoning from the other side of this conversion process that some mutual funds may undertake.

Dziubinski: Now, if I own a mutual fund that is going to be converted into an ETF, is that a taxable event for me?

Johnson: The conversation of a mutual fund to an ETF will not be a taxable event for mutual fund shareholders. Their basis will remain intact. What, ultimately, investors will enjoy is effectively a form of tax deferral that they wouldn't otherwise benefit from if that fund were to remain a mutual fund, see continued in some cases in persistent outflows, which in recent years have resulted in these large and regular capital gains distributions. So again, the ETF being somewhat unique in that it has that regular mechanism by which it can get rid of securities, meet redemptions without unlocking gains, which are kind of a negative externality created by what's either regular or in some cases, bad behavior, on the part of fellow fund shareholders. Those externalities aren't socialized across all fund shareholders. They're externalized in the case of the ETF. The people who are buying and selling are the ones who are paying the taxes and absorbing a lot of the transaction costs that otherwise would be internalized by the fund.

Dziubinski: Ben, what are some of the most notable conversions that we've seen so far or that we expect to occur in 2021?

Johnson: Well, we've only seen one conversion to date, and it actually was a hedge fund, a small hedge fund that became an ETF in the first week of 2021. That said, we've seen a small handful of asset managers, included among them Guinness Atkinson, and most notably Dimensional Fund Advisors, announced that they're looking to convert a number of their mutual funds to ETFs. And the DFA announcement, which happened in mid-November of 2020, is really the most meaningful to date. At that point, Dimensional let the world know that at some point in 2021, it will be converting six of its tax-managed mutual funds into ETFs. These six funds combined held over $30 billion in investors' assets. They've seen persistent outflows in recent years. And in some cases, they've seen regular and sizable capital gains distributions. So, given that these six funds were designed for what we can reasonably assume are acutely tax-sensitive investors, I think this is welcome news for them given all the benefits we've discussed of the ETF vehicle, as it pertains to deferring those taxes, realizing them as you choose as you liquidate as opposed to when others choose to liquidate.

Dziubinski: Given all the advantages of the ETF structure, do we expect to see more of these conversions as time goes on?

Johnson: I expect that we will see more conversions as time goes on, but I don't think what you'll see is going to be a sweeping replatforming of the mutual fund industry onto an ETF chassis. There are any number of different impediments that can make this logistically complex, including the fact that ETFs trade like securities. So, clients who own ETFs need to have a brokerage account. Not all fund shareholders necessarily have a brokerage account today. It might not be linked to the account where they have their mutual fund holdings. There's some paperwork and some plumbing issues there that could make this incrementally more challenging.

The benefits, too, of the ETF wrapper aren't necessarily going to shine through for all mutual fund investors. Many mutual funds are predominantly invested in defined-contribution channels, for example, retirement plans, 401(k)s. The benefit of tax efficiency is really a moot point in the context of a tax-deferred wrapper. So, I would expect that many investors really wouldn't see the appeal and wouldn't get any benefit from having mutual funds that they own in their retirement accounts converted into an ETF format.

The other important point to take into account is kind of the portfolio management aspect, if you will. One of the all-important capabilities that portfolio managers have in mutual funds is that, when they're worried about capacity, when they're worried about plying their strategy successfully, and they see money coming into the fund, they have the ability to implement either a soft or a hard close and say, "I've got enough on my plate. I don't want to invest at these valuations in my best ideas, or I don't want to invest in my 51st best idea in order to accommodate new money coming into the portfolio." Well, when managing a strategy in an ETF, that option is taken off the table. ETFs, except under very extreme circumstances, cannot close at the portfolio manager's discretion, so capacity management is an all-important question that managers who are mulling a mutual fund to ETF conversion should be taking very seriously, as should the investors in those funds.

Dziubinski: Well Ben, thank you so much for your time today, helping us unpack this mini trend that we're starting to see between mutual funds and ETFs. We appreciate your time.

Johnson: Thanks for having me.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.