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.