This is the first in a series of columns by CFRA's Head of ETF Data and Analytics Aniket Ullal, in which he'll be sharing exclusive insights on ETF industry expectations for 2023.
Defined Outcome ETFs Catch a Wave
ETF Industry Draws Political Battle Lines
About $40 billion of mutual funds have converted into exchange-traded funds over the past two years, and the trend shows no sign of slowing heading into 2023.
The roots of the development trace back to the beginning of the U.S. ETF industry in 1993, with the launch of the SPDR S&P 500 ETF (SPY), the first listed in the U.S. Since then, the ETF structure has become one of the most successful product innovations in asset management in the last 50 years. As of Dec. 7, the U.S. ETF industry had $6.6 trillion in assets across more than 3,059 listings.
Like traditional mutual funds, most U.S. ETFs are registered under the Investment Company Act of 1940. However, ETFs have big differences from traditional mutual funds. Unlike traditional funds, ETF shares are bought and sold on an exchange and are priced throughout the trading day. The process by which ETF shares are created and redeemed is also different, giving it tax advantages over traditional funds.
Also, until 2008, all ETFs in the U.S. tracked indexes (i.e., were not actively managed) and were typically low cost. This combination of tradability, tax efficiency and low-cost index exposure drove the adoption of ETFs, and they took market share from traditional mutual funds, which were introduced in 1924
Figure 1 shows the relative share of mutual funds and ETFs of total investment company assets over the last 20 years through the end of 2021. In 2002, ETFs accounted for only 1.5% of aggregate U.S. investment company assets. That share had grown to over 20% by the end of 2021. While traditional U.S. mutual fund assets have grown at a 7% annual rate in that 20-year period, U.S. ETF assets have grown at 24% annually, an exceptional growth rate for a relatively mature asset management market.
It is important to note that this asset growth reflects both the appreciation in underlying holdings and net new flows. A comparison focusing solely on flows would tilt the comparison even more heavily in favor of ETFs.
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The Incumbent’s Dilemma
The disruptive growth of ETFs necessitated the leading mutual fund managers to confront the classic incumbent’s dilemma: whether and how to participate in the emerging ETF segment. Initially, most chose not to launch ETFs. However, in the last few years, leading fund managers like T. Rowe Price, Neuberger Berman and Capital Group have entered the industry.
New ETF entrants, no matter their pedigree or track records, faced uphill battles acquiring market share from the three entrenched players—BlackRock (iShares), Vanguard and State Street (SPDR). Some firms, most notably Invesco, have addressed this by acquiring smaller ETF issuers.
Another option was to convert existing mutual funds into ETFs. This became easier after the “ETF Rule” was adopted by the Securities and Exchange Commission in 2019. This rule (6c-11) under the Investment Company Act allowed ETFs to be launched without requiring exemptive relief approval from the SEC, subject to certain conditions, such as active ETFs disclosing their holdings daily.
Another option for fund managers might be the launch of ETFs as a share class of their existing mutual funds. This dual-class structure is currently patented by Vanguard and comes off patent in 2023.
Converting funds to ETFs has potential advantages, such as the ability to retain the funds’ performance record and the opportunity to scale quickly by capitalizing on investor interest in ETFs. Other advantages could include tax efficiency and lower operational costs. However, there could be downsides, such as potential revenue loss from existing higher fee funds, one-time costs, and the complexity of conversion and channel conflict issues.
Since 2020, some asset managers have opted to convert existing mutual funds to ETFs. The first firm to complete a conversion in the U.S. was Guinness Atkinson, which converted two mutual funds to ETFs under its SmartETFs brand in March 2021.
As of Dec. 7, there was over $40 billion in ETF assets from converted funds. It indicates that the transition strategy has been successful, especially for firms like Dimensional Funds and JPMorgan, which have recognized brands. Table 1 provides some examples of the converted funds.
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Coming Tidal Wave?
Although $40 billion is a meaningful asset total for converted funds, it still represents less than 1% of U.S. ETF assets. From the perspective of investors, most fund conversions are likely to be a positive development, since ETFs generally have lower fees and more disclosure than traditional active mutual funds.
JPMorgan and Fidelity have already announced plans for fund conversions in 2023. If additional firms take this route, the conversion trickle could become a tidal wave and will be an important ETF trend to track in 2023.