Asset managers continue to convert some of their mutual funds into exchange-traded funds. So what does that mean for investors? A 2019 change to the rules governing investment funds made it easier for managers to convert mutual funds to ETFs by removing the need for separate approval of each potential conversion by the Securities and Exchange Commission.
A handful of asset managers, including Dimensional Fund Advisors and JPMorgan Chase & Co.’s J.P. Morgan Asset Management, have recently converted actively managed mutual funds into actively managed ETFs. They say the change is in response to the preference of many investors for ETFs, which generally offer lower fees than mutual funds and provide a tax advantage.
Investors in the funds being converted might appreciate those benefits. But they need a brokerage account to keep the new ETF, and may have some tax consequences if they own fractional shares of the mutual fund.
Why convert?
The initial group of conversions has mostly been in actively managed stock or bond funds. For example, J.P. Morgan completed conversions of four funds in June, an actively managed fixed-income fund now called JPMorgan Inflation Managed Bond ETF (JCPI); an active equities fund, now JPMorgan Market Expansion Enhanced Equity ETF (JMEE); a real-estate income fund, now JPMorgan Realty Income ETF (JPRE); and a global equities fund, now JPMorgan International Research Enhanced Equity ETF (JIRE).
Dimensional Fund Advisors converted a $30 billion suite of actively managed systematic funds last year. Systematic funds’ investment decisions are largely guided by models based on extensive market data, rather than left purely to the fund managers’ discretion.
Analysts say actively managed funds are likely to be where most conversions happen. That’s because active funds have higher fees than passive ones and tend to generate more taxable gains through trading, which makes them more vulnerable to investors’ preference for lower fees and taxes.
There is a recognition among asset managers that there is a better way to offer certain strategies, and that’s coming alongside investor demand for ETFs,” says Daniel Sotiroff, a Morningstar analyst. Even mutual funds that already have some of the qualities of an ETF can benefit from conversion, he says. “If you look at what Dimensional converted, those funds were already tax managed as mutual funds,” meaning they were designed to minimize investors’ tax burden. “The ETF structure makes that process easier to do and comes with lower fees.”
He notes that ETFs typically don’t charge the so-called 12b-1 fees that mutual funds do. These fees, which are named after the SEC rule that allows them to be charged, cover the marketing and distribution of a mutual fund or ETF. ETFs also tend to have fewer trading transactions than mutual funds, which means they have lower transaction costs, because trades aren’t triggered by asset inflows and outflows in ETFs as they are in mutual funds.
ETFs offer a tax advantage because, since they can make fewer trades, they distribute fewer, if any, capital gains to investors. Some mutual funds are designed to distribute fewer gains, but investors are still likely to see taxable distributions over the course of their investment in a mutual fund.
The higher fees of actively managed funds and the taxes on capital gains from distributions have led to outflows in favor of actively managed ETFs with similar strategies for a number of years. The SEC rule change for conversions gives investors the option to stick with the same strategy and managers at a lower cost.
For fund managers, a conversion allows them to keep the performance record of the mutual fund as well as any investor assets in the fund that stay through the conversion. That can give the new ETF a leg up over a newly launched ETF, as many investors and financial advisers want to see a substantial record and enough assets to support the long-term viability of a fund before investing.
What to watch for
For investors in a mutual fund that is up for conversion, there are a few things to keep in mind. Those who invested in a mutual fund through a transfer agent instead of a broker, which is common, will need a brokerage account to be able to hold and trade the ETF. If they don’t have a brokerage account, there are many low-cost brokers, with some offering low or no minimums to open an account, but it may be a bit of a learning curve for those who haven’t used a brokerage account before.
ETFs also don’t offer fractional shares. Any fractional shares of the mutual fund held at the point of conversion will be redeemed and could result in a taxable gain.
A conversion may also require approval from shareholders, and if enough shareholders don’t want to convert, fund managers may opt to offer a separate ETF that runs the same strategy. Individual investors can then decide to move into the ETF on their own, but that could result in tax consequences when they sell out of the mutual fund if they end up with capital gains.
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Source: When a mutual-fund converts to an ETF: How it works | Mint
Critics by By Matthew Romano
Mutual fund” is the common term for an investment vehicle that pools money from multiple investors and invests in various assets such as stocks and bonds. Most traditional mutual funds, commonly referred to as “open ended” funds, issue shares directly to shareholders and redeem them at the demand of the shareholder at the fund’s net asset value (NAV). Mutual funds register with the SEC under the Investment Company Act of 1940 (the Act).
While an exchange-traded fund (ETF) is similar to a traditional mutual fund in that it pools money into a fund to invest in various assets and can register with the SEC under the Act, it differs in that its shares are traded on a secondary market as opposed to directly between the shareholders and the fund. One or more intermediaries, referred to as authorized participants, seed the fund with cash and/or stocks in exchange for the fund shares and then list those shares on a secondary market to be bought and sold by the prospective fund shareholders.
A traditional mutual fund can be converted to an ETF. The present discussion focuses on the tax implications of doing so. A conversion may be appealing because of the greater tax efficiency of ETFs (discussed below), lower expense ratios, and the fact that a conversion utilizes the scale and performance of an existing fund. Mutual funds’ appetite for converting was further enhanced by the SEC’s approving Rule 6c-11 in 2019, which reduced the time and cost of launching an ETF.
Tax efficiency of ETFs
Both traditional mutual funds and ETFs that are domestic corporations — if they are registered with the SEC under the Act and meet certain diversification, income, and distribution requirements — are taxed as regulated investment companies (RICs) under Subchapter M of the Internal Revenue Code. Under these rules, they are not subject to entity-level tax if they distribute their net income and capital gains via dividends to their shareholders. Shareholders with nonqualified taxable accounts ultimately bear the tax burden.
ETFs are often more tax-efficient than traditional mutual funds, however. In the case of a mutual fund, besides the trading that occurs in the normal course of business, other transactions at the fund level can result in an increased tax burden for the shareholders. For instance, a portfolio rebalance and/or change in investment strategy can result in the fund’s recognizing substantial gains. Large redemptions can also cause a mutual fund to recognize gains because it may need to sell securities to raise the cash to meet the redemption request.
The ETF structure can mitigate or even eliminate this tax burden. With respect to redemptions, Sec. 852(b)(6) provides that a RIC that redeems shareholders with “property” instead of cash will not recognize any gain from the disposition of that property. While this provision applies to both traditional mutual funds and ETFs, mutual fund shareholders will almost always prefer a cash redemption, while authorized participants are usually indifferent.
With respect to a rebalancing of the portfolio, ETFs can utilize either a redemption basket (of securities) or a creation basket (of securities) between the ETF and the authorized participants. This allows the ETF to avoid recognizing and distributing taxable gains to the shareholders.
The conversion transaction itself
While the conversion of a traditional mutual fund to an ETF has numerous legal and operational hurdles, the details of which are outside the scope of this discussion, the tax structuring is fairly simple. Typically, the fund sponsor will create a shell ETF for purposes of the conversion. This ETF will likely have the same investment objectives, board of directors, and management as the original mutual fund. After the shell ETF is created, the original mutual fund merges into the shell ETF.
If structured properly, the merger will qualify as a tax-free reorganization under Sec. 368(a)(1)(F) (F reorganization). The requirements of an F reorganization, detailed in Regs. Sec. 1.368-2(m), are listed below:
- Immediately after the F reorganization, all the stock of the resulting corporation, including any stock issued before the potential F reorganization, must have been distributed in exchange for the stock of the transferor corporation.
- The same person or persons must own all the stock of the transferor corporation and of the resulting corporation in identical proportions.
- The resulting corporation may not hold any property or have any tax attributes immediately before the F reorganization.
- The transferor corporation must completely liquidate as part of the transaction.
- Immediately following the potential F reorganization, no corporation other than the resulting corporation may hold property that was held by the transferor corporation immediately before the reorganization.
- Immediately following the potential F reorganization, the resulting corporation may not hold property acquired from a corporation other than the transferor corporation.
Given the nature of the conversion of a traditional mutual fund to an ETF, it is likely that the transaction will meet the above requirements. Assuming it does, an F reorganization is considered a “mere change of form” for tax purposes. As such, the fund tax year end, employer identification number, and all tax attributes from the original mutual fund remain.
There are some other ancillary tax implications of the conversion. The mutual fund may want to sell some assets prior to the conversion; this could result in some taxable distributions to shareholders. Also, unlike traditional mutual funds, ETFs generally do not issue fractional shares, so these will be redeemed with cash prior to the conversion and could result in a nominal amount of tax.
Other items to consider
While this item focuses primarily on the tax impact, some nontax aspects of converting a traditional mutual fund to an ETF should also be considered:
- Shareholders may need to set up a brokerage account to hold the ETF shares.
- Unlike traditional mutual funds, ETFs can trade at a premium or discount to NAV, which can create some level of risk to the shareholder. However, the create/redeem process between the ETF and the authorized participants can operate to reduce any premium or discount spreads.
- Approval by the mutual fund’s board of directors may be required to complete this transaction.
Potentially significant benefits
While substantial operational and legal obstacles need to be considered and addressed, the conversion of a traditional mutual fund to an ETF can have significant tax benefits, depending on the nature of the fund’s activities and the makeup of the fund shareholder base.
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