Since March 2021, more than 50 mutual funds with $60 billion in assets have converted to ETFs. Triggered in part by the seemingly ever-growing popularity of ETFs, more of these conversions are on their way.
Here’s what you need to know about this investing trend and how it might impact you.
Why some mutual funds are converting to ETFs
It’s not clear yet that converting to an ETF will ensure a fund can attract more investors. Nevertheless, the trend of mutual funds converting to ETFs has accelerated, with significantly more expected in the near future.
There are several reasons behind this trend. Near the top of the list: Investors generally love ETFs, with soaring fund flows into ETFs as evidence. In the case of most mutual funds that have converted to an ETF, the fund company has hoped to attract more investors to the ETF compared with the mutual fund.
Another factor that has helped fund companies decide to convert some mutual funds to ETFs is that the converting fund retains historical performance. Oftentimes, this may be beneficial for attracting investors that prefer established funds whose historical performance can be assessed. This can be an advantage compared to setting up a new ETF with no performance track record and similar investing objectives to the mutual fund being converted.
Here’s how the process typically works. After a fund company decides to convert a specific mutual fund to an ETF, there are several steps to complete. Typically, the fund company will notify the mutual fund’s existing investors of their intention. In some cases, this may require a shareholder vote to approve the conversion. Thereafter, most of the operational aspects of the conversion are the responsibility of the fund company. It’s worth noting that investors in a converting mutual fund without a brokerage account may need to open one to hold the ETF after the conversion is complete. Once approval is granted and all other steps are completed, the fund's assets convert tax-free to an ETF.
For investors, one of the main benefits of an ETF is its potential tax efficiency. Once converted to an ETF, the fund can take advantage of the potential tax benefits afforded by the creation and redemption mechanism of ETFs. Also, ETFs feature daily trading, enhanced transparency, and typically have lower fees relative to a mutual fund.
In 2023, Fidelity converted 6 disruptive-themed mutual funds to ETFs:
- Fidelity Disruptive Automation ETF (
- Fidelity Disruptive Medicine ETF (
- Fidelity Disruptive Communications ETF (
- Fidelity Disruptive Finance ETF (
- Fidelity Disruptive Technology ETF (
- Fidelity Disruptors ETF (
With that said, there are some drawbacks and impediments. For example, the fund manager may not prefer the enhanced transparency of an ETF, and mutual funds that are included in 401(k) plans are unlikely to be a candidate for conversion, as most of these retirement plans offer mutual funds or collective investment trusts only.
Although there are several structural differences (see table below), the objective of the new fund is typically similar to the mutual fund. For example, in November Fidelity is converting 6 enhanced index funds to ETFs. The investing objectives of each of these new ETFs will generally be the same as that of the mutual fund it will be converted from.
|Potential benefits||Potential drawbacks|
|Converted ETFs retain mutual fund performance record.||Many mutual funds that have been converted thus far have tended to be relatively smaller funds with short performance history, which may limit the usefulness of retaining performance record.|
|Relative tax efficiency.||Mutual funds commonly have multiple share classes, whereas ETFs only have one class. The mutual fund manager will need to determine the share class that most closely resembles the new ETF share class structure, which may have investing implications for existing investors.|
|Lower costs (due to lower transfer agency and shareholder servicing costs, lack of 12b-1 fees, and no state registration fees).||Availability of the converted ETF shares may be different than that of the mutual fund shares.|
|Most ETFs feature enhanced transparency relative to mutual funds.||Enhanced transparency of ETFs compared to mutual funds may impact a manager's investment strategy (although non transparent ETFs are not subject to the same daily disclosure requirements of traditional ETFs).|
|Conversion of an existing mutual fund may provide a fund company easier entry to the dense ETF market.||Mutual funds may have greater capacity (the ability to close off the fund from new investments that may erode performance if the fund grows very large).|
If you own a mutual fund that a fund company has signaled their intention to convert to an ETF, it can help to understand what this conversion may entail. And if this trend continues, more mutual fund investors may be impacted.