Conversion or Share Class: The Mutual Fund CEO’s Dilemma

Last year investment flows out of active mutual funds hit a staggering -$572 billion. Flows into ETFs, active and passive, reached a record $1.4 trillion. This continues a trend going back 15 years. Despite this trend out of the over 540 mutual fund families in the US an astounding 75%, over 400, still do not offer ETFs at all. And of the over 120 who offer both wrappers many or most have failed to achieve any real scale.

Until the last few years if you were a mutual fund CEO who wanted to establish yourself in the ETF space you had two routes you could go. The fastest was to buy an established ETF issuer who had scale and whose operations would blend with yours. But that is expensive and choices limited. Plus, mergers don’t always work out well.

Your second choice was to offer ETFs as separate offerings. This is what the 120 mutual funds mentioned above have done. The large number that have failed to gain traction in terms of assets suggests this is also not an easy process.

The last few years two additional choices have emerged. The first is to convert your existing mutual fund, and its AUM, into an ETF. Over 185 funds have made such a conversion and total AUM in those ETFs is over $260 billion. A late 2024 report by Merrill Lynch covering the first 120 mutual funds to convert showed that, pre-conversion, almost all the funds were seeing outflows regardless of if the fund out-performed or under-performed their benchmarks. Post conversion showed positive inflows for almost all out-performers and positive inflows, or much reduced out-flows, for those that under-performed.

If you convert half a dozen of your mutual funds into ETFs, and those mutual funds had billions in AUM, then on day one of being ETFs you already have critical mass. If this also solves your out-flow problem than, based on early results, conversion seems a no-brainer.

The other option is the newest. It is to offer your ETF as a class within the mutual fund structure. This allows your ETF to essentially “piggyback” off the existing AUM of the mutual fund. It also allows a mechanism for the mutual fund shareholders to share in some of the tax efficiencies of the ETF structure.

We decided to ask a number of veteran senior ETFs executives about these two new options. Here is what they had to say.

Laura Morrison

LAURA MORRISON is one of the best-known and most well-respected executives in the ETF industry. She spent almost 30 years running ETF listings at both CBOE-BATS as well as the New York Stock Exchange. More recently, she was Chief Revenue Officer at Direxion.

HYLAND: Laura, the mutual fund-ETF share classes. What are your thoughts here?

MORRISON: There is a lot of talk about this new approach, but I have two concerns. First, do investors really want to buy ETFs that are part of a mutual fund if there is a similar standalone product? You can see that the new arrangement provides a tax advantage to the mutual fund shareholders since the fund can use the creation/redemption process of the ETF to help mitigate realized capital gains. But what do ETF investors actually get out of this?

If distribution, sales and marketing resources are not aligned, there is a good chance that a fund family will introduce this new share class approach and just not see any new money flowing into the ETF share class. If so, will this help to at least slow down the outflows from the mutual funds? If no, does this help at all?

My second concern is I think it seems clear that the brokerage platforms do not like this approach. They will likely slow walk it as fund groups try to introduce it, which will further make it harder to gain any asset gathering traction because the exchange mechanism / conversion between share classes may not be available until the end of 2026 or possibly into 2027.

HYLAND: Other issues?

MORRISON: It raises the question of whether the multiple share class is really just going to be a transition device for fund families to move from mutual funds to ETFs, raising Reg BI [“Best Interest”] concerns and operational friction compared with standalone ETFs. In that case, maybe they should just make the conversion sooner rather than later.

HYLAND: And if you move to conversions?

MORRISON: Are clients asking for the ETF wrapper? Often the client shares that they like your strategies but prefer the ETF wrapper; however, the distribution team knows MF and have enjoyed the pay structure. If conversion to an ETF takes place, the team will likely not know who the end investor actually is (unless the client proactively shares), that salesperson is concerned about how they get paid. It's very important to focus on compensation and education for the external & internal sales teams, distribution, portfolio managers, product strategies as well as every other division that will influence the success of offering an ETF wrapper.

HYLAND: The question of how well the mutual fund distribution team will handle also selling ETFs is a big one. Traditionally they fail badly at it. Thank you Laura.

Dan Dolan

DAN DOLAN is one of the most veteran ETF executives in the U.S., in particular in regard to sales and distribution. He oversaw the growth of the Sector SPDRs from their start in 1998, with $500 million, to over $330 billion in AUM when he retired a few months ago. Few people, if any, in the ETF industry can match his tenure or level of success.

HYLAND: Dan, you have seen the struggles of mutual funds coming in late to the ETF space to achieve critical mass. What are your thoughts about how new players can try and scale using the strategies above?

DOLAN: CEOs will need to analyze their distribution model and determine where most of the assets are currently held. If they have large holdings in the 401K space, the new share class approach could make more sense. For many, the conversion is more attractive. The ETF structure is just better for investors long-term. Either way, they need to make a real commitment because the sales model will change and they will need to have all parties fully on board……You need everyone to buy in first. Make the commitment, start with a few conversations and then launch new product. Be patient, particularly with the sales team.

HYLAND: Real commitment as a key. Given the weak experience of many of the 120 fund companies that already went into ETF suggests that commitment, and not just lip service, is not always present. Thank you, Dan.

Richard Kuhn

RICHARD KUHN is the Head of Product at Thornburg Investment Management. Before that, he spent almost 20 years at Invesco in similar roles and has seen lots of product rollouts. Thornburg was a traditional issuer of mutual funds that started offering ETFs just under a year ago but has also filed for the combined share class approach.

HYLAND: Let's talk about doing conversions.

KUHN: Conversions depend on many factors and circumstances. As I guided these conversations at Thornburg, we carefully worked through a number of considerations, including: Is a conversion in the best interests of our shareholders? Who are the shareholders? Which share class are they invested in? What are the arrangements shareholders have with their financial advisors? The fact that conversions seem to have worked well for DFA and JPMorgan suggests that they did a lot of this homework. No two firms are alike, so I don't think you can make a blanket assumption that a converted mutual fund will be successful and not experience outflows.

HYLAND: And the mutual fund-ETF share classes?

KUHN: ETF share classes are just starting to come online after years of regulatory review, and at Thornburg, we’re excited to be among the very first to receive approval and implement this solution. This path can also help ease a mutual fund to ETF transition, but it’s not without risks and operational hurdles. There’s no denying that the ability to grow a fund with a new share class is attractive.

Daniel Madden

DANIEL MADDEN is the head of ETF Capital Markets at Thornburg. Before that, he spent over 20 years trading ETFs at a number of market makers and is one of the most veteran traders in the industry. 

HYLAND: Dan, what about these various strategies from a capital markets, trading of the ETF, perspective?

MADDEN: It is always more difficult to trade an ETF with only a few million in AUM. It is hard to achieve optimal results with creation and redemption activities and tight bid/ask spreads. On the other hand, consider a $4 million ETF that is a share class of a $400 million mutual fund. The larger overall fund size offers greater flexibility in designing deliverable baskets that help mold portfolio trading, creation, and redemption activity to the portfolio management style. 

HYLAND: So multiple share classes can help solve the problem of trading sub-scale ETFs. What about the case of converting the $400 million mutual fund into a $400 million ETF?

MADDEN: In my experience, this also makes the capital markets issues work out for the better. Both approaches—conversion and multiple share classes—are very helpful from a capital markets perspective.

HYLAND: Thank you both.

The conversion strategy so far has proven that it works for those who have tried it, but it may not work as well for all mutual fund families—particularly those with a lot of 401(k) assets. On the other hand, it can be implemented immediately, it gets you into the ETF space with scale on Day 1, and if you are already suffering outflows the downside seems limited. You might lose some AUM that you likely were going to lose anyway.

There remain a lot more questions, and therefore risks, about how well investors will receive the mutual fund-ETF multiple share class. With renewed inflows or with a big yawn? An ETF with $8 million in it, which is a share class of an $800 mil mutual fund, in some investor’s eyes may still be viewed as “just” an $8 million ETF and thus passed over. In addition, keeping the mutual funds means keeping the mutual fund sales force. Historically fund companies that try to have their traditional mutual fund distribution team also sell ETFs have failed miserably. 

If the multiple share class does fail to solve the mutual fund CEO’s outflow problem, it may be another 3-5 years of continued outflows before that becomes apparent and then they are exactly where they are today but with 5 years, and a lot of AUM, gone. Finally, if the multiple share class is really just a bridge to get from all mutual funds to all ETFs, as was suggested, then it would be faster, and maybe less risky, to just go with the conversions in the first place?

Mutual fund CEOs get paid a lot of money to make decisions. Few decisions they will make in the next two years are going to be more important than their decision about getting into the ETF market. At the moment they have two distinct paths they can take. Choose wisely.

Disclaimer: The market insights, projections, and investment strategies expressed in this article are solely those of the contributor and do not necessarily reflect the views or opinions of ETF.com. This content is provided for informational purposes only and does not constitute financial, investment, or legal advice.