John Hyland, CFA, is a retired ETF executive and longtime investment industry professional who has contributed articles to ETF.com.
One of the biggest topics this year in the ETF space is the pending launch of a new type of actively managed but nonfully transparent ETFs.
These ETFs would allow active managers to offer their portfolios without having to reveal each day what they are buying and selling and the risk being front-run by traders or competitors.
That concern helps explain why many mutual fund companies have still steered away from getting into the ETF space, despite the fact that the ETF wrapper is generally both cheaper and more tax efficient for their investors than the traditional mutual fund wrapper.
Most of the attention so far has been focused on the notion that a mutual fund company would elect to use the new style wrapper to launch clones—or near-clones—of their successful active mutual funds.
The ETF version of an active mutual fund could be cheaper, by reducing shareholder servicing and distribution costs, and would generally be more tax efficient. Offering both versions certainly has significant appeal for both the investor and the mutual fund family.
However, the real play here instead may be converting the mutual fund into an ETF and dropping the mutual fund structure altogether.
Since active ETFs could be both cheaper and more tax efficient than active mutual funds, there may be little long-term reason to prefer the mutual fund wrapper over the ETF wrapper. Given that there is about $10 trillion of assets in active mutual funds, this trend, once established, could be huge.
But before get carried away with the idea of trillions of dollars of mutual fund assets changing their structure, we need to ask an obvious question: Can you even do it?
To help answer this question, we’ve called upon two veteran mutual fund and ETF attorneys. Tom Conner and Deborah Eades are partners at law firm Vedder Price, and each has decades of experience in the mutual fund and ETF space.
Can a conversion even be done legally?
Tom Conner: Well, a conversion is going to be a major task, and is not for the faint of heart, but we believe there’s a clear regulatory roadmap to having a successful conversion.
Is there only one way to do a conversion legally?
Deborah Eades: There are two basic approaches to convert an actively managed mutual fund to an active, nonfully transparent ETF. One is where a mutual fund company does all the work to set up the active ETF first, and then, before the ETF lists, reorganizes the mutual fund into the new ETF. So the mutual fund shareholders become the ETF shareholders, and the mutual fund’s assets become the ETF’s assets.
Then there’s a direct conversion where the mutual fund changes its current structure, including potentially changes to governing documents, fee structure, shares class structure and its registration statement to become an active, nonfully transparent ETF.
Does one way have a clear advantage over the other?
Conner: Individual circumstances will dictate the best method for a particular fund or fund group.
While a direct conversion appears simpler, it will likely raise a lot more legal issues to be dealt with, big and small, which always tends to drive up the cost and timeline of getting the conversion finished.
We don’t see any particular downside to structuring the conversion as a reorganization of a mutual fund into the ETF since mutual-fund-to-mutual fund mergers have been around for a long time.
Our group at Vedder Price has structured and closed hundreds of those types of mergers—some of them quite complex—so that seems a more tried-and-true path.
Say you are the managers of a family of mutual funds. How do you start the process of conversion?
Eades: The fund managers will need to identify strategies that are suitable for conversion, identify and develop solutions for operational hurdles, talk the structural choices through with their legal and tax counsel and select their preferred approach.
Then they need to explain to the mutual fund’s board, including the independent directors, what they’re proposing. The board will want to know the costs and timeline for the conversion, what will likely happen to the fund’s total expense ratios after the conversion, any tax implications, and what sort of trading costs, in terms of bid/ask spreads, will shareholders selling the new ETF in the future likely face.
What happens after board approval?
Conner: The next steps will be to determine whether or not to engage in informal discussions with the SEC staff. If you’re the first to try it, you may want to talk it over with them. If you’re the fifth firm to go down this route, maybe not.
After that, you need to determine whether a shareholder vote is required, identify and address operational hurdles, and draft and file either amendments to the mutual fund’s prospectus and SAI—if this is for a direct conversion—or a new registration statement if this is for a merger.
What are likely to be the biggest challenges to getting the conversion completed? Getting it all through the SEC? Rounding up shareholder votes?
Conner: The initial conversions will likely involve significant discussion with SEC staff members, but we don’t see any legal or regulatory issues that can’t be resolved. It’s not a given that you’ll need a shareholder vote, depending on certain variables and how the conversion is structured. If a shareholder vote is required, that will involve the typical challenges and expense of soliciting proxy votes and obtaining a quorum, and could impact timing.
What are the remaining major tasks to be dealt with after SEC approval?
Eades: The mutual fund company and/or the new ETF will need to hold special board meetings; revise documents and agreements; file an ETF exemptive application; draft and file prospectus supplements and/or a new registration statement; and identify and resolve operational issues.
At the same time, you’ll need to deal with the listing stock exchange, market makers and APs, your custodian bank, your audit firm, and your own sales and distribution staff—pretty much what you go through if you were starting any new ETF from scratch.
Plus, you’ll need to consider what happens to shareholders who hold the mutual fund shares directly with the fund, who want to own the new ETF shares but don’t currently have a brokerage account. You don’t want to leave them in the lurch.
What are the tax implications upon conversion?
Eades: A direct conversion is not a taxable transaction, because no exchange of assets or shares is involved.
If the reorganization approach is used, it can likely be structured as a tax-free reorganization under the rules that normally apply to fund reorganizations, which generally means there would be no tax impact as a direct result of the conversion.
How long does the process take?
Conner: Assuming you go with a mutual fund reorganization into an active ETF, it seems reasonable that process will take nine to 12 months—longer if you’re the first to try this, but it should go faster if you’re following others.
No Reinvention Needed
So the ability to do these sorts of conversions is real. The next questions are, will mutual funds actually do it, and if yes, how soon before we see them act?
Discussions at the recent Inside ETF Conference suggest that, yes, mutual fund companies are already looking at this approach. The best estimates are that they’ll move forward on this front much sooner than most people might expect.
None of this would mean that the mutual fund industry is going away anytime soon. Rather, the landscape will change, and an entire new approach will become a major feature of it.