Mutual funds and exchange-traded funds (ETFs) have existed side-by-side for decades. Originally, ETFs were largely deployed for passive, index-based strategies. They surged in popularity due to an array of benefits including tax efficiency, low-cost, trading flexibility, and product choice. No other fund type is undergoing as much growth as ETFs. The 10-year annual growth rate of US ETF assets under management (AUM) is 26%1 pushing the US ETF AUM to nearly $4 trillion.2 ETF product development has also evolved over this period with the introduction of more complex quantitative ETF strategies, as well as growth in actively managed strategies in the ETF wrapper. However, ETFs typically require their holdings to be published daily, providing a great deal of transparency into the underlying trading methodology. Some managers see this as a risk others will reverse engineer their proprietary trading strategies and accordingly, have remained on the ETF sidelines.
On May 20, 2019, that all changed with the Securities and Exchange Commission’s (SEC’s) approval of Precidian Investments’ ActiveSharesSM actively-managed ETF structure – the first ETF that is not required to disclose its portfolio daily.3 The approval may open the door for additional semi-transparent ETF methodologies now pending SEC approval. It’s not surprising then, that as the ETF transparency requirement may more closely resemble that of a mutual fund, more managers are revisiting the ETF wrapper.
While managers may consider launching an ETF clone of an existing mutual fund, many disfavor that approach for fear that the ETF would cannibalize the assets of the mutual fund. The more traditional approach is to launch a new strategy in an ETF wrapper, but this method requires the injection of seed capital and time to reach break-even asset levels. Consequently, managers are considering reorganizing existing mutual funds into ETFs, which solves the problems of the other two methods and may allow managers to continue to utilize the fund's performance track record. This edition of Exchange Thoughts discusses the legal, business, and operational considerations for turning a mutual fund into an ETF.
The altered regulatory landscape
For years, the SEC has been unwilling to permit the reorganization of a mutual fund into an ETF. The staff viewed such reorganizations with disfavor for a variety of reasons, including the perception that ETFs, which could only offer market price to an investor, were less liquid than mutual funds, which always delivered net asset value per share.
Recent discussions with the SEC indicate a new willingness to entertain proposals to reorganize into an ETF. While the SEC no longer seems to harbor fundamental philosophical objections, they have expressed concern with the fairness to shareholders of any such reorganization. This emphasis on fairness will mean a close regulatory focus on the mechanics of the transaction and the shareholder impact.
How to make the switch
Any manager’s goals in a reorganization will include the portability of the mutual fund’s performance to the ETF and the continuity of regulated investment company (RIC) tax treatment. Managers can meet these goals through either (1) a conversion of the mutual fund into an ETF, or (2) a reorganization of the mutual fund into a new affiliated ETF via a merger, meeting the requirements of Rule 17a-8 under the Investment Company Act of 1940 (the “1940 Act”).
In a conversion, there is no transfer of assets and the ETF wrapper replaces the mutual fund wrapper in the existing trust with the same governing board. Such a conversion requires, at a minimum, an amendment to the fund’s Form N-1A registration statement, an amendment to the trust agreement to provide for ETF series share creation and redemption methodologies, and an evaluation as to whether a shareholder vote is required or desirable.
In a Rule 17a-8 affiliated funds merger, the mutual fund series merges into a new ETF series either of the same trust or a new affiliated trust. The merger is deemed to be an asset transfer for accounting purposes, which generally allows the historical mutual fund performance to become that of the ETF. If the requirements of Rule 17a-8 are met, the 1940 Act will not require a shareholder vote to accomplish the merger. The ETF series will register its offering on Form N-1A and the merger will be registered on a Form N-14 containing the mutual fund’s information statement (or proxy statement if a vote is otherwise required or desired) and the ETF’s prospectus.
SEC relief and exchange listing rules
All ETFs need some form of exemptive relief under the 1940 Act to operate. Among other things, these exemptive orders are predicated on representations that all ETF shares will be issued and redeemed in creation units (e.g., 50,000 shares) in transactions directly with authorized participants (APs). Under these exemptive orders, retail investors can only transact in ETF shares in the secondary market at trading prices in brokered transactions. Any reorganization will require an evaluation of the ETF’s exemptive relief to either structure the transaction to comply with the conditions of the order or potentially seek further relief from the SEC to allow the reorganization despite the conditions of the ETF’s existing order.
An SEC ETF rule proposal is currently pending for final adoption that will eliminate the need for individual exemptive orders for daily transparent ETFs.4 The rule proposal specifically allows for the reorganization of mutual funds into ETFs without compliance with creation unit issuance requirements. Nevertheless, managers contemplating operating an ETF under a transparency substitute method, such as Precidian’s, will not be covered by the rule as proposed and will need to procure an exemptive order.
Unlike mutual funds, ETFs must comply with their stock exchange’s listing rules. Many traditional ETFs generally enjoy generic listing standards that permit their shares to trade. However, some ETFs may not qualify for generic listing and may require bespoke approval from the exchange and the SEC. Note that while Precidian has received an order under the 1940 Act, they and their exchange are currently in the process of procuring a bespoke listing rule for ActiveShares ETFs.
Operational considerations: Process fairness and other issues
Adequacy of notice
The adequacy of both the content and timing of a notice of the reorganization to the mutual fund shareholders will be one of the more important procedural fairness issues for the SEC. The content of such notice should be sufficient for shareholders to evaluate the impact of the proposed reorganization on their financial interests. For example, the disclosures should contain a clear and concise explanation of ETF share market pricing, bid/ask spread, associated risks, etc. The timing must be adequate to permit any shareholder who does not want to receive ETF shares to redeem the mutual fund shares prior to the transaction.
Treatment of direct shareholders
Some mutual fund shareholders may hold their shares directly with the mutual fund. All ETF shares, in contrast, are held in a book-entry only form through the Depositary Trust & Clearing Corporation (DTCC) and individual shareholders are unable to open direct accounts with the ETF. This feature of ETFs raises a host of considerations, including:
- The ability to communicate with these shareholders will be critical for the fund manager and likely involve the mutual fund’s transfer agent, distributor, and the firm’s sales or client service organization.
- Direct shareholders will need to move to a brokerage account (who is a DTCC participant) to receive ETF shares or receive a cash payout for their mutual fund shares.
- Any cash payout for direct investors may have adverse tax consequences.
- A mutual fund’s dividend reinvestment plan (DRIP) will be terminated upon a reorganization as ETF DRIPs are typically offered via the investor’s broker-dealer.
- Auto investing and dollar-cost averaging will no longer be available to shareholders of the ETF.
Either a fund conversion or a merger would result in changes to how the fund’s expense ratio is comprised. The vast majority of ETFs are structured using a unitary fee, generally matching the investment advisory (IA) fee. If the advisor, investment objective, and strategy remain consistent from the mutual fund to the ETF, then the IA fee would likely remain the same as well. However, some managers may choose to lower this fee component to better compete with other ETFs. Under a unitary fee structure, investors are not typically charged 12b-1 and ‘other’ fees by an ETF that externalizes distribution charges, revenue sharing, and provider costs from the fund and shareholders. Managers should be cognizant of their ETF peer group and where similar products are priced. BBH’s ETF Investor Survey has shown a consistent theme in recent years that ETF expense ratios are a critical element for advisors when selecting a product.
In the US, ETFs only have one share class and firms should consider the best path forward to collapsing the mutual fund share classes ahead of a reorganization to an ETF, if necessary. Managers will need to consider which share class presents the best performance and track record to maintain and carry to the ETF, and which share class fee structure may be similar in structure to the ETF – this may be an institutional share class or equivalent versus classes with 12b-1 fees or sales loads. Additionally, a clear road map on transitioning a multi-class fund will require communication to shareholders and intermediaries, helping to maintain shareholder suitability.
One main driver of managers seeking to convert mutual funds to an ETF is potential negative tax consequences resulting from mutual funds sitting on large unrealized capital gains. ETFs that allow for in-kind creation and redemption activity typically enjoy a reduced tax footprint from mutual funds, as in-kind trading is tax exempt. Managers can select which tax lots to relieve via in-kind redemptions, thus reducing the taxable gains passed along to shareholders. For mutual fund managers, this is a major benefit of ETFs. Managers considering an ETF reorganization should be aware that any unrealized gains or losses in the mutual fund will carry over to the ETF. Depending on the reorganization event, the transition may be a tax-free event and the basis could remain the same post-transition. Under this scenario, the new ETF may be able to transfer out highly appreciated assets when redemption orders are placed by the funds’ APs.
- Managers should work with their tax advisors and regulators to better understand how any unrealized gains can be treated in an ETF reorganization.
- Fund managers should assess their investor base across taxable and non-taxable accounts today to identify those at risk of a taxable event.
- It is likely regulators and fund boards could view any tax event resulting from the fund reorganization as a negative consequence to shareholders, making its approval more difficult.
Business considerations: Are you ETF ready?
While ETFs enjoy many of the same operational requirements as a mutual fund, there are unique, day-to-day requirements that a firm must be aware of and monitor to support a new ETF business. The calculation and delivery of the portfolio composition file (PCF), the receipt of creation and redemption orders from APs, and the use of in-kind trading may present nuances and additional operational requirements for managers considering a fund reorganization. Firms should look to educate not only their internal constituents but confirm their providers have the capabilities needed to support ETFs.
Firms may consider adding staff or assigning some of their team to the ETF business. For example, most ETF firms employ a Capital Markets group (or individual) who is responsible for building relationships with APs, monitoring trading and spreads, approving creation and redemption orders, and presenting ETF activity to the Board. This is often a new role for traditional mutual fund firms and one that will often lead to discussions with APs, exchanges, market makers, and other ETF ecosystem partners. Ideally, this role would be part of a reorganization road map given its widespread integration in the ETF market.
Additionally, a firm’s 38a-1 compliance program may need to be amended to account for exchange-based trading, monitoring of spreads, and APs. Chief Compliance Officers as well as Chief Operating Officers will likely need to affirm to their Board in advance of the fund reorganization new controls and oversight that will be implemented to support the new ETF business.
Firms will also need to examine their underlying strategy and positions to ensure it will meet their exemptive relief and listing standards. For firms looking at the Precidian ActiveShares model, the exemptive relief currently only allows for US exchange-traded securities. As mentioned previously, for traditional ETFs, the listing exchanges will examine the portfolio to ensure it complies with their generic listing standards or determine if a Rule 19b-4 filing may be required. Beyond these considerations, managers should be aware that APs will want to discuss the portfolio and ensure it’s tradable, the costs associated with trading and hedging, and better understand the portfolio strategy.
Lastly, and perhaps most importantly, are the impacts an ETF business can have on a firm’s distribution team. As ETFs trade over the exchange, it can be difficult to track underlying buyers of the products. Sales teams may need to consider how they can access this information from third-party data firms or from their intermediary partners, likely with additional costs. While ETFs do not charge 12b-1 fees to shareholders, revenue sharing arrangements with intermediary partners do exist between the ETF issuer and the respective platforms. As firms enter the ETF market, they should engage their distribution partners to better understand any potential changes to the economic model ETFs may present.
Incentivizing the sales team to market the ETFs may be part of potential changes to distribution strategy and sales compensation firms should consider. Training sales professionals on the nuances of the ETF wrapper will also be critical as their wholesaling efforts will likely require commentary on how best to trade the new product, and spread analysis, and connections to liquidity providers (e.g. market makers). Installing a Capital Markets person or hiring an ETF specialist within the sales team may aid in these training discussions during the reorganization process as well as on-going product support.
Managers should asses their preferred option: merger or conversion. Once managers have decided, they should begin engaging the new ETF ecosystem participants:
- Broker dealers
- Capital markets
Over the past 15 years, Brown Brothers Harriman (BBH) has partnered with more than 40 asset managers to bring ETFs to market in the US, Europe, and Hong Kong. BBH has worked with Precidian and their licensees as well as other third-party providers to support the ActiveShares ETF model. We are readily available to discuss fund conversions in more detail and welcome the opportunity to engage with firms in deeper dialogue about this development.
K&L Gates LLP represents index-based, leveraged, and actively managed ETFs, their sponsors, and boards of directors in all legal aspects of designing, developing, organizing, registering, and operating ETFs. Our clients include ETFs that invest in equity and fixed-income securities as well as commodities-referenced exchange-traded products. Are you ETF ready? K&L Gates LLP can help.
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1Source: NYSE NYSE Arca as of December 31, 2018.
2ETFGI, as of June 2019
3Investment Company Act Release No. 33477 (May 20, 2019) (“Order”)
4Proposed Rule 6c-11 (Investment Company Act Release No. 33,140 (June 28, 2018) (“Proposing Release”)).