Big Asset Avalanche Coming To ETFs

[ETF Pulse appears Mondays and Thursdays. Drew Voros is Editor-in-Chief of ETF.com.]

An avalanche is one of the most frightening curveballs Mother Nature throws.  

You see most weather coming–granted earthquakes not so much–but in terms of being sneaky, I would take an earthquake (I’ve been through the 6.7 Northridge in 1994) over an avalanche any day.

While you don’t see an avalanche coming, it’s ultimately right in front of you, as are most things in life.

After five feet of snow falls rapidly in the California/Nevada Sierra and more at the high peaks, it looks lovely, sparkling like a Tyrus Wong-animated Disney scene backdrop.

But alongside what looks placid and picturesque looms danger, danger the snowy mountains of assets the mutual fund industry has been blind to. Those sounds crackling beneath the dangerous drifts are coming from the ETF industry.

Avalanches Start Slowly

The slightest of sounds can trigger the avalanche, which starts slowly and then rapidly intensifies. Over the next few years, the collapse of mutual fund assets will be brought about by ETFs melting the market share of giant mutual fund firms, while they pretend there’s no danger in their long-secure landscape.

Seasoned alpine people don’t walk around or ski with AirPods in their ears. Nature tells you through sound that something’s coming your way, like the roar of a bear, thunder or an avalanche.  

Many huge mutual funds have been walking below the avalanche listening to music rather than the terrain. Even after years of ETFs eroding their assets, they don’t seem to fully grasp the magnitude of what’s coming down the mountain toward them.

Mutual Fund Assets Melting

Interestingly, it’s smaller issuers laying the tracks for what will be a wall of assets sweeping into ETFs—between mutual fund conversions to ETFs and for young investors who know ETFs from the start—that will feed the mutual fund asset tumble.

But it’s clear as day that mutual fund money is melting away.

ETFs gained $427 billion in 2020, while mutual funds lost $469 billion. Obviously, ETFs still have a long way to go in terms of catching up to the level of assets in mutual funds, but mutual funds keep looking the other way as their fund assets slip away.

Conversions let them keep their track record and assets rather than starting from scratch.

Unlikely Trailblazers

While not a boom or a bang, a firm out of nowhere sparked what’s likely to be a trend of mutual-fund-to-ETF conversions.

Guinness Atkinson converted two of its existing mutual funds into ETFs in a nontaxable event as of March 29 of this year. The Guinness Atkinson Dividend Builder Fund (GAINX) and the Guinness Atkinson Asia Pacific Dividend Builder Fund (GAADX) are now the SmartETFs Dividend Builder ETF (DIVS) and the SmartETFs Asia Pacific Dividend Builder ETF (ADIV), respectively.

“Nontaxable event” was key in the press release. That has been the crutch old mutual funds have used, indicating that such conversions would be painful for their investors at any scale. But the truth is that these conversions can be effected fairly.

The SEC has given very clear signals that it’s OK to jump into the ETF pool if you’re a mutual fund. In April, more ski tracks were laid. This is directly from the SEC website on taxes (from Investor Bulletin: Mutual Fund Conversion to Exchange-Traded Fund (ETF)):

“Find out if you will otherwise owe taxes because of the conversion. Generally the conversion from a mutual fund to an ETF is structured so as not to be a taxable event to shareholders. But if the mutual fund sells investments in its portfolio prior to the conversion, it may result in a recognition of capital gains for the mutual fund which could lead to taxable distributions to shareholders. If that happens, you may owe taxes on these distributions.”

And the agency had this to say on tax efficiency:

“Mutual fund investors holding shares in a taxable account generally have to pay taxes on any capital gain distributions they receive from the mutual fund. ETF investors may also have to pay taxes on any capital gains distributions from the ETF. However, because many ETFs buy and sell portfolio securities in in-kind exchanges (rather than for cash), they typically have fewer capital gain distributions than mutual funds and hence ETF shareholders pay less in taxes on a similar investment.”

Then there was DFA, an unlikely firm to be open to ETFs with its gated entry for investors and advisors. It followed on Guinness Atkinson’s heels to convert a handful of its tax-managed mutual funds into ETFs. Our friend and former US Commodity Funds CIO John Hyland wrote this for us (from DFA Crashes ETF Party. Who’s Next?):

“Although not the first mutual-fund-to-ETF conversion, Guinness Atkinson converted two funds in March and Adaptive Investments converted one in May. What differs here is the scale of the conversions. While those three mutual funds converted held less than $200 million in assets, the four DFA funds hold almost $29 billion in assets…. One of the immediate impacts of these conversions is that it vaults DFA from being the 50^th largest ETF issuer—it already had three existing ETFs with $1.6 billion in AUM—to now being the 13^th largest issuer, with seven ETFs and more than $30 billion.”

 See … it’s easy.

Drew Voros can be reached at [email protected]