ETF conversions are accelerating, and we are seeing more and more mutual funds converting into ETFs. The reasons for a mutual fund to ETF conversion are obvious: tax efficiency, transparency, and lower operating costs.

But how does this work? What are the pros/cons? This post provides a glimpse behind the curtain and a practical guide for any asset manager considering a mutual fund conversion. Below we outline the laws behind a mutual fund conversion, options for mutual fund conversions, and the nitty-gritty behind how to optimize a mutual fund conversion.

Before we get started, here is a shameless plug: if you want to convert your mutual fund into an ETF, you can use our trust, convert on your current trust, or contact us for consulting support. We’ve also written a ton of blogs on how to launch ETFs, which serve as an FAQ on ETF operations.

Finally, maybe you aren’t an ETF sponsor but simply a mutual fund shareholder subject to an ETF conversion. This post will shed some light on the process and provide a step-by-step guide to understanding what would happen to your mutual fund shares.

Why do an ETF conversion?

In our view, ETFs are a no-brainer (for most strategies). It’s like comparing a horse and buggy to the Model T. Sure, a horse and buggy may have some redeeming qualities, but the future is with Ford. Same with ETFs.

Below are the key reasons to convert a mutual fund.

  • Tax efficiency – If your money is taxable, this is a no-brainer.
  • Operational efficiency – For an operator, ETFs can potentially be less capital-intensive and operationally easier to manage. Daily inflows do not have to be continually traded and monitored. Tax loss harvesting is removed via the in-kind redemption process. In short, you will soon find yourself with a lot of mutual fund management horsepower that can be repositioned into other roles.
  • Lower cash drag – less cash to manage, less cash to drag.
  • Broader interest/model portfolios. We talk to RIAs daily, and we have never encountered an adviser interested in a model portfolio of mutual funds. Similarly, no one calls our office asking for a comparison of X ETF fund to Y mutual fund. It just isn’t happening. The market appetite for ETFs is here; the market appetite for mutual funds is mostly gone.

Laws behind a mutual fund conversion 

There are two paths for mutual fund to ETF conversions: direct conversion and reorganizations. A direct conversion occurs when a mutual fund converts into an ETF and remains in its existing trust. A reorganization occurs when a mutual fund is proxied to a new Trust (typically one specializing in ETFs), and shareholder approval is required.

Regardless of the path you choose – mutual fund conversions involve pain. Reorganizations deliver pain upfront; direct conversions deliver pain after the fact. But rest assured, either approach will require some elbow grease. For the examples below, I assume that you are comfortable with the “transparent” ETF approach. If you need semi-transparent ETFs, add the Exemptive Relief process to either of these paths.

Direct conversions – Deceptively Simple

The Direct Conversion method is simple but involves a material commitment to building internal ETF operations accordingly.

In a direct conversion, the Fund prospectus is changed, the organization docs of the Trust are evaluated, and if lucky, you can “convert” your mutual fund within its current trust (See Rule 17a-8 of the Investment Company Act of 1940). Easy right?

In a direct ETF conversion, managers are spared a proxy (unless their Trust docs mandate one), and more importantly, they are spared from having to reach out to clients. Many may not be aware of the mutual fund or, more importantly, the fees associated with such a holding. “I own what? How much am I paying?”. Some managers prefer to let sleeping dogs lie.

Let him sleep

But with direct conversions come direct responsibilities. The minute your Trust hosts an ETF, it is subject to a myriad of rules, regulations, and nuance that mutual funds are not a party to. More importantly, Independent Board members are expected to have oversight of these matters and documentation thereof. If a mutual fund board has grown accustomed to the “good life” under mutual funds, ETF oversight is a jolt to the system. Similarly, the Fund Adviser will be responsible for monitoring and implementing trading, compliance, vendor oversight, etc., etc. You are effectively launching a new asset management firm within an existing firm.

Granted, this is all certainly possible. Just be sure to have a good operations plan and lay the groundwork upfront…way up front.

Finally, you ask incumbent service providers to perform new, augmented services. This will also require diligence, mutual agreement to contract terms, board approval, etc.

Reorganizations – Proxy required, but heavy lifting outsourced

A reorganization is technically a “fund merger.” A shell fund is created on a new Trust (often with very similar characteristics – fund name, strategy, portfolio manager, etc.). The standalone fund is reviewed and approved by the Fund’s board and the SEC (much like a traditional ETF). In parallel, a Form N-14 is prepared, which outlines to the SEC, “Here is how the merger will work, and here are the key similarities and differences between the old and new fund.”

A skilled attorney will ensure both the Shell Fund and the Form N-14 are palatable to the SEC (hint: identical fund strategies and lower fees on the ETF side help). Once the SEC and board bless all docs (Fund Reorganization, New Fund Prospectus), the filings are made. Shareholder materials are printed, and the proxy process begins.

I’ve never done a proxy before…how does that even work?

Proxy efforts can be highly complex efforts or relatively straightforward. It all boils down to shareholder concentration. To win a proxy, 50% of shares outstanding must vote, and 2/3 of them must vote in the affirmative. The hardest part is simply getting people to vote (regardless of preference).

The first step is running a shareholder analysis via the Transfer Agent. That data will show you the 80/20 of where the shares are. If 50 people hold 80% of your shares…that’s a pretty easy proxy. If 50,000 people hold 80% of your shares…that’s a harder proxy (note – we did one of those successfully – it’s doable).

Once you have identified the concentration, it is necessary to understand how the shareholders will be approached. If you are providing lower fees and tax efficiency, this is a pretty compelling value proposition. Shareholder letters, voicemails, webinars, etc., can all be part of the plan.

Based on the concentration, you may want to leverage a proxy solicitation firm to help get the votes. We have seen engagements ranging from $10k to hundreds of thousands of dollars. Again, it all depends on concentration. In our view, the best approach is to work in tandem with any proxy agent you choose. The outreach must be a team effort. You will bring deep knowledge of your shareholders. They will bring hundreds, if not thousands, of proxy efforts to the table.

Finally, don’t be afraid to put in the work, particularly with your biggest clients. This is an opportunity to rekindle conversations with valued partners and celebrate the next step of a fund’s life. Handwritten cards, phone calls, etc., are low-cost / high-touch gestures that show shareholders that they matter. In short, don’t outsource your outreach entirely. Be a part of the process.

The proxy agent will tabulate the votes and help facilitate the shareholder meeting alongside a reputable 40Act law firm. All-in costs here (all approvals, proxy with known shareholders, shareholder meeting) can range from $100k (cheap) to several hundred thousand or more.

Reorganizations Part II – operational matters

Operational matters for ETF conversions are critical, and the more advanced preparation, the better:

  • Minimize/eliminate direct shareholders. Some shareholders will hold shares directly with the Transfer Agent instead of with a particular brokerage firm. These accounts will have to have an account opened for them. Otherwise, the TA will hold them as “zombie” accounts for an extended period. Some N-14s liquidate direct shareholders at conversion. Whatever you do, assess how many direct shareholders you have and minimize them to the greatest extent possible.
  • Consolidate your share classes. ETFs can not operate multiple share classes in most cases, so eliminating these in advance will make your life a lot easier.
  • Fractional shares. ETFs do not issue fractional shares, so any fractional shares must be redeemed or addressed before conversion.

A skilled operator on the ETF side will manage all of this, but it is good to be aware of what they will be working on.

Concluding Remarks on ETF conversions

So…there you have it. As ETFs grow in popularity, so will these types of reorganizations. The bottom line about ETF conversions is simple: know your clients and your capabilities, and leverage partners/attorneys/operators to get you there.