ETF Conversions’ Pitfalls Eyed

January 13, 2023

With mutual-fund-to-ETF conversions accelerating, experts caution that despite benefits reaped by some issuers, the change doesn’t guarantee boosted profits. 

Swapping mutual funds into exchange-traded funds is a growing practice, with nearly 40 mutual funds having been reborn as ETFs since the first switch in March 2021, according to ETF.com data.  

About $40 billion in assets have switched so far, and another $60 billion to $80 billion may convert this year, CFRA Head of ETF Data & Analytics Aniket Ullal projects. And more than $1 trillion may convert over the next decade, Bloomberg Senior ETF Analyst Eric Balchunas says. 

At the same time, so-called separately managed accounts are also increasingly converting to ETFs, the Financial Times reported

Still, experts say that if a strategy isn’t successful in a mutual fund wrapper, there’s little reason to believe it will be successful as an ETF. Also, the benefits of conversion are also paired with potentially material drawbacks. 

Looking at the converted ETFs leading the way in 2022 in terms of assets, almost all inflows went to large, already established products from major issuers, namely Dimensional and JPMorgan.  

For example, the first two ETFs that converted from a mutual fund structure, the $3.5 million SmartETFs Asia Pacific Dividend Builder ETF (ADIV) and the $21.4 million SmartETFs Dividend Builder ETF (DIVS) have been largely flat in terms of flows from the time of their conversion to the end of last year.  

“I sometimes use the equation of a dog food bowl and the dog food—you can change the bowl, but the dog does have to want the food in the bowl,” Balchunas told ETF.com in an interview.  

Larger issuers often invest in-house assets in their own ETFs, and if a fund has significant assets, it’s already off to a solid start, one expert said.  

“If you have a strategy that was successful in a mutual fund, it's certainly not going to be unsuccessful as an ETF, and is likely going to create an additional market for investors in that you'll continue to have the same appetite from the mutual fund investors for that strategy,” said Richard Kerr, a partner with law firm K&L Gates and a member of its asset management and investment funds practice group, in an interview with ETF.com. 

Kerr noted the flip side to that idea: “I don't necessarily think that if you have an unsuccessful mutual fund that converting it to an ETF is going to cause it to be successful. There's either a market for the strategy or not.”  

Drawbacks & Pitfalls 

Beyond whether a fund is a success or not, there are different components that go into managing an ETF versus a mutual fund. Kerr said that issuers should make sure they’re prepared to deal with the expenses and operational changes.  

“Operating an ETF requires managers to be able to do things that they've never had to do before, including monitoring the arbitrage process and the bid/ask spreads in the market, and engaging with market makers in a way that mutual fund organizations have not had to do,” he said, adding that the change requires significant training for existing staff, or possibly bringing in someone from outside the firm with the relevant experience. 

Kerr suggested further that a firm should determine whether a conversion is beneficial to its customer base, noting that difficulties may arise in moving customers without a brokerage account into one that permits trading ETFs.  

Balchunas speculated that issuers of larger, more established mutual funds, such as Fidelity’s Contrafund, may not want to convert to an ETF structure simply because they make too much money from the mutual fund wrapper, where higher fees are the norm. Further, they may be wary of the potential for cannibalization.  

He also pointed to the Fidelity Magellan ETF (FMAG), which is a clone of the Fidelity Magellan Fund. Although the mutual fund was once the largest in the world and currently has nearly $25 billion in assets under management, its ETF version launched about a year ago, and despite its brand, only has about $40 million in AUM.  

“You'd almost think on name recognition alone, this would do a little better, even with nobody selling it. But it just shows you how the world has turned both with high costs and active,” Balchunas said. “Investors are not the same. They're seeking certain things certain ways, and this just doesn't fit the times.”  

 

Editor's Note: See Part 1: ETF Industry's $1T Mutual Fund Grab

 

Contact Heather Bell at [email protected] 

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