In this third episode of our ETF podcast series (recorded on December 20, 2020), Ropes & Gray asset management attorneys Jeremy Smith, Brian McCabe, and Ed Baer discuss converting an existing mutual fund into an ETF and the related legal and operational issues.
Jeremy Smith: Hello and thank you for joining us today on this Ropes & Gray podcast. I'm Jeremy Smith, a partner in the New York office of Ropes & Gray. Joining me today are two of my colleagues from the asset management practice group, Brian McCabe, a partner in our Boston office, and Ed Baer, a counsel in our San Francisco office. In this podcast, which is part of a series of podcasts on ETF issues, we will provide a high-level overview of key considerations in converting an existing open-end mutual fund into an ETF. Ed, Can you tell us why the topic of converting mutual funds into ETFs is coming up now?
Ed Baer: Sure. Back in early-2019, a number of us at Ropes & Gray had conversations with clients and potential clients about how a sponsor might go about converting a mutual fund into an ETF, so we started to organize our thoughts about what a conversion might entail. And then the SEC approved the Precidian non-transparent active ETF exemptive order. We thought the ability to launch an actively-managed ETF that doesn’t have to disclose portfolio holdings on a daily basis might bring enthusiasm to the idea of a conversion. So in May 2019, we published our initial white paper on converting mutual funds to ETFs, and suddenly there was a lot of buzz about doing conversions.
Jeremy Smith: Thanks. Brian, with the idea of doing a conversion gaining acceptance, why have we still not seen a completed conversion yet?
Brian McCabe: Well, that’s because reality settled in. As we wrote in this 2019 white paper, while there’s no legal reason that a mutual fund couldn’t convert to an ETF, there are a number of practical and operational challenges that have to be overcome. That’s what we and our clients, and in fact much of the asset management industry, have been grappling with. But it looks like the first mutual fund to ETF conversion will happen pretty soon. Several sponsors have taken steps to convert existing mutual funds into ETFs. Two Guinness Atkinson mutual funds are planning to convert to ETFs before the end of the year, and two other fund firms—Starboard and Dimensional Fund Advisors—have announced their intention to convert mutual funds to ETFs. We’ll discuss the Guinness Atkinson proposal in more detail in just a few minutes.
Ed Baer: So Jeremy, why now? What has changed about the ETF market that’s motivating these sponsors to pursue conversions at this point?
Jeremy Smith: There are a couple of factors. First, the long-awaited ETF Rule was approved in 2019, and so the path to launching an ETF family has become a bit easier and less uncertain. And second, the number of semi-transparent ETFs with exemptive relief to operate without making their full holdings publicly available has proliferated and those ETFs that have launched using those models have been able to operate with spreads in line with expectations for the products. These developments have prompted many new sponsors to enter the ETF market, and converting existing mutual funds to ETFs may offer an appealing way for these sponsors to enter the market with scale and a performance track record.
Ed Baer: Okay. Brian, can you briefly talk about what the ETF Rule offers sponsors and ETF shareholders?
Brian McCabe: The ETF Rule permits sponsors to create and launch transparent ETFs without having to obtain exemptive relief. The ETF Rule also eliminates the difference in treatment between passive or index ETFs and active ETFs, and permits ETFs to utilize custom creation and redemption baskets. The ETF Rule offers sponsors a very quick path to launching and listing an ETF. ETFs that are able to operate pursuant to the ETF Rule also will be able to take advantage of existing exchange listing rules and SEC market trading relief, meaning that they can come to market without having to overcome additional hurdles. Plus the ability to use custom baskets under the Rule will enable ETF sponsors to benefit shareholders by realizing the tax efficiency and lower transaction costs offered by the ETF wrapper.
Jeremy Smith: Brian, what about non-transparent or semi-transparent active ETFs? How do they fit into this equation?
Brian McCabe: Well, Jeremy, beginning in 2019, the SEC granted exemptive relief to a number of ETF sponsors that permits actively-managed ETFs to operate without being subject to the current daily portfolio transparency condition included in past active ETF orders and in the ETF Rule. Basically, these ETFs fall into two groups – ETFs based on the Precidian model and ETFs that follow one of the so-called “proxy portfolio” models promoted by T. Rowe Price, Fidelity, Blue Tractor, Natixis/NYSE and Invesco. But there are differences between the Precidian model and the Proxy Portfolio models.
Ed Baer: That’s right. The Precidian model and the various Proxy Portfolio models permit active equity ETFs that don’t disclose their portfolio holdings on a daily basis. The models all contain features that are designed to ensure the efficient operation of the arbitrage mechanism, but they take different approaches. The Precidian model provides no daily disclosure of portfolio holdings to APs and other market participants, and creations and redemptions are handled confidentially by a broker-dealer selected by the creating or redeeming AP known as an “AP representative.” In this model, a verified intra-day indicative value or VIIV is published throughout the day to allow APs to assess arbitrage opportunities in the ETF’s share price. In contrast, the Proxy Portfolio models promoted by Fidelity, T. Rowe Price, Natixis/NYSE, Blue Tractor and Invesco are often referred to as “semi-transparent” models, which provide some transparency into the ETF’s holdings and the baskets available to APs and market participants on a daily basis. These Proxy Portfolio models are broadly similar in that they provide a measure of daily portfolio transparency to APs and other market participants, but they differ from each other in the amount of transparency they provide and then how they shield portfolio trades.
Brian McCabe: So, how does a sponsor go about obtaining semi-transparent active ETF relief? Jeremy, can you walk us through the available options?
Jeremy Smith: I’d be happy to. An ETF looking to shield its portfolio holdings from other market participants will need to obtain exemptive relief from the SEC. This relief can be either “short-form” relief, which would be based on exemptions obtained by other sponsors, or it could be novel relief. Short-form relief has recently been obtained in as little as two-three months using an expedited process, while novel relief typically takes longer. Many active equity managers are looking into licensing one or more of the previously-approved models, or seeking their own relief. While licensing another sponsor’s model will add to the cost of operating a semi-transparent active ETF, it may result in a faster time to market.
Brian McCabe: This is a great opportunity for active managers who might be worried about giving away their “secret sauce” to break into the ETF business, but there are some conditions that limit the utility of these active models for some strategies. At least for now, an ETF operating under one of the approved models is permitted to hold only exchange-traded securities that trade synchronously with the ETF’s shares, such as U.S. common stocks, ETFs, ADRs and other equities, as well as cash and cash equivalents. An ETF operating under these models also can’t borrow money or hold short positions. Active equity managers that need more flexibility are limited to transparent ETFs for the time being.
Ed Baer: Now that ETFs following some of these models have been launched, how are they doing?
Brian McCabe: So far, pretty well. ETFs utilizing the Precidian, Fidelity, Natixis/NYSE and T. Rowe Price models have been launched, and ETFs based on the Blue Tractor and Invesco models are in the works. Spreads and premiums and discounts on those products that have been launched have been within ranges that are typical for newly-launched U.S. equity ETFs. Of course, these products are new and have not yet been tested in extreme market environments, but early indicators are positive.
Jeremy Smith: Alright. Now that we know what the available ETF structures are, let’s talk more about how to go about converting a mutual fund to an ETF. Brian, can you tell me about what a sponsor will have to do to effect a conversion?
Brian McCabe: Sure. Mutual fund sponsors contemplating a conversion will need to be able to explain to the funds’ boards the basis on which they can find that the conversion is in the best interest of the funds and, in the case of a merger, that existing shareholders will not be diluted as a result, consistent with Rule 17a-8 under the ‘40 Act. The Board will need to understand the structural differences between mutual funds and ETFs, especially the arbitrage mechanism and the creation and redemption processes, and the implications of the conversion for shareholders, including:
- The loss of the right to redeem individual shares;
- The need for shareholders of the ETF to designate or establish a brokerage account in order to trade the ETF shares following the conversion transaction;
- The intra-day liquidity provided by the ETF structure;
- Changes to the Fund’s principal investment strategies and how the Fund has historically invested;
- The expected portfolio turnover, transaction costs and tax consequences that will be incurred in connection with the conversion;
- The costs of the conversion and who will bear them;
- The trading costs (in terms of bid-ask spreads) expected to be borne by existing shareholders;
- The timeline for the conversion;
- The expected effect of the conversion on the Fund’s total operating expenses;
- The sponsor’s ability to facilitate an effective arbitrage mechanism through arrangements with APs; and
- The potentially significant tax benefits of operating as an ETF.
Ed Baer: That’s really helpful. One thing you said was critical to consider – the tax implications of the conversion. The good news is that the conversion of a mutual fund to an ETF should not in itself have any significant negative tax consequences to the mutual fund, the ETF, or their shareholders. As Brian noted, there are generally ongoing tax benefits to operating as an ETF rather than as a mutual fund. However, given the unique nature of the semi-transparent active ETFs, there may be additional tax considerations or limitations relevant to such ETFs under the Internal Revenue Code. For example, any disposition of securities prior to the conversion to transition the portfolio to comply with the conditions of the relevant relief or to address the impact of redemptions of those shareholders who decide to redeem prior to the conversion may result in the recognition of capital gain, which would be required to be distributed to shareholders in taxable distributions.
Brian McCabe: Another critically important consideration for the Board is whether a shareholder vote is required or recommended. Jeremy, are there any rules here?
Jeremy Smith: There are. If the conversion will be effected by a merger, approval by the mutual fund’s shareholders may be required under a variety of corporate law or regulatory regimes. Rule 17a-8 under the 1940 Act generally permits mergers between affiliated funds, subject to certain conditions, and would not require shareholder approval if certain conditions are satisfied. Generally, Rule 17a-8 permits a merger between a mutual fund and an affiliated ETF without a shareholder vote if the advisory agreements and fundamental policies of the mutual fund and the ETF are not materially different, independent Board members of the mutual fund who were elected by its shareholders represent a majority of the independent Board members of the ETF, and the ETF does not have a Rule 12b-1 plan that authorizes greater payments for distribution than does the mutual fund’s Rule 12b-1 Plan. Also, the laws of the state under which a mutual fund or ETF is organized may require a shareholder vote prior to effecting the conversion or merger, or the Declaration of Trust or other organizational documents of the mutual fund or the ETF may also require shareholder approval.
Brian McCabe: Interesting. So what are the steps to converting a mutual fund to an ETF?
Ed Baer: One of the first things to consider is what form the conversion will take. The conversion can either be a direct conversion or a merger. In a direct conversion, the mutual fund converts into an ETF by amending its fund documents and its registration statement as necessary. In a merger, the mutual fund merges into a shell ETF, generally through an asset sale. In either case, you’ll also need to apply for exemptive relief for semi-transparent active ETFs or establish policies and procedures to comply with the ETF Rule for ETFs with daily transparency. Other steps that may be necessary include adjusting the mutual fund’s portfolio to be compliant with the conditions of any applicable exemptive relief and consolidating share classes to accommodate the typical single-class structure of ETFs.
Brian McCabe: Jeremy, what are some of the other significant practical and operational challenges?
Jeremy Smith: Converting a mutual fund into an ETF raises important business considerations, including, among others, the effects of the conversion on existing mutual fund shareholders and on existing agreements among a mutual fund, its distributor and/or its transfer agent, and various intermediaries that sell mutual fund shares and provide services to mutual fund shareholders. Unlike ETF shares, which are held through brokerage accounts, many mutual fund shares are held directly with the mutual fund. Mutual fund shareholders will need to establish a brokerage account in order to buy and sell ETF shares they receive as part of the conversion. Prior to the conversion, the sponsor may wish to identify accounts for which there is no designated broker-dealer, and work with affected mutual fund shareholders to establish brokerage accounts. Sponsors may wish to assist these mutual fund shareholders by establishing a mechanism for these shareholders to open brokerage accounts conveniently. Finally, unlike mutual funds, ETFs typically do not issue fractional shares. In a direct conversion, any existing fractional shares of the mutual fund may need to be redeemed prior to the conversion. The conversion of fractional shares to cash would likely be treated as a taxable event to shareholders affected.
Ed Baer: Are there other considerations?
Brian McCabe: Yes. Sponsors should work closely with their service providers and intermediaries to ensure a smooth transition. It’s also important for sponsors to be mindful of the mutual fund’s distribution arrangements. Because the distribution models for mutual funds and ETFs differ significantly, sponsors should engage with its distribution partners to ensure a smooth transition for investors. This may involve hiring an ETF capital markets specialist to engage with APs, market makers and other market participants. Also, the ETF creation and redemption process differs from the mutual fund purchase and sale process, and for ETFs, it functions as part of the portfolio management process. Portfolio managers will have to understand the differences in processes. In addition, it will be necessary to establish a creation and redemption infrastructure for the ETFs, including establishing relationships with APs and market makers, preparing an AP agreement, preparing creation/redemption order guidelines, and compliance policies and procedures, including basket construction policies. Finally, ETFs operating under the ETF Rule are permitted to engage in custom basket transactions, which allow for greater flexibility in selecting securities to use in meeting redemption requests.
Jeremy Smith: Okay. Why would a sponsor prefer an ETF structure to a mutual fund structure?
Ed Baer: I think there are a number of factors, mainly including the tax efficiency and lower costs of ETFs, as well as investor interest.
Jeremy Smith: I hear that a lot. Can you elaborate on those points?
Ed Baer: Well, because ETFs often don’t have to sell securities to meet redemption requests, ETFs typically recognize fewer capital gains than equivalent mutual funds. ETFs can generally minimize capital gains by satisfying redemption requests using the lowest cost basis lots of each instrument that is part of the ETF’s redemption basket. Also, ETFs don’t typically have to maintain a cash position or sell securities to meet redemptions, and therefore, may operate with less cash drag and lower transaction costs. ETFs also bear significantly lower transfer agency and shareholder servicing costs than mutual funds, and most ETFs do not pay Rule 12b-1 fees. Unlike mutual funds, ETFs are also not subject to state registration (or so-called “blue sky”) fees. Further, ETFs often don’t make revenue-sharing payments to intermediaries. As a result, many investors have been drawn to ETFs by their relative tax efficiency and lower operating costs, as well as the ability to trade shares intraday using flexible order types, and the ability to lend, pledge, margin and sell their shares short. ETFs are often the preferred vehicle in model portfolio arrangements, and most robo-advisors predominantly utilize ETFs in their portfolio solutions. These are some of the reasons fund sponsors are interested in launching ETFs and potentially converting mutual funds to ETFs.
Jeremy Smith: Alright. Brian, let’s focus on the conversions that have been proposed. Guinness Atkinson was the first to signal their intent. What are their plans?
Brian McCabe: In September, Guinness Atkinson filed a prospectus/information statement describing its plans for the conversion of two mutual funds into ETFs. They’re looking to complete the conversion before the end of the year. In their filing, Guinness Atkinson urges shareholders who hold their shares directly with the Fund’s transfer agent to open a brokerage account and have their existing fund shares transferred into that account. The filing also notes that if a shareholder’s broker is unable to accommodate fractional shares, any fractional shares will be redeemed in cash as part of the conversion. Also, there are express conditions on the reorganization, including satisfactorily resolving comments from the SEC staff, and the listing exchange and establishing agreements with APs.
Ed Baer: Do we know what approaches Guinness Atkinson and the other firms that have announced an intention to complete conversions are taking to shareholder approval?
Brian McCabe: Guinness Atkinson and Dimensional don’t appear to be seeking shareholder approval. However, Starboard does plan to ask shareholders to approve their conversion. It will be interesting to see how other sponsors will address the shareholder approval issue going forward.
Jeremy Smith: Indeed. This is all very interesting, and it may just be the tip of the iceberg. The conversions proposed by a prominent firm like Dimensional, and the size of the mutual funds they plan to convert into ETFs, may open the floodgates for other sponsors. That brings us to the end of the podcast. Brian, Ed and I want to thank all of you for joining us on this discussion of the potential conversion of a mutual fund into an ETF. For more information on the topics that we discussed or other topics of interest to asset managers and ETF sponsors, please visit our website at www.ropesgray.com, where we have links to some additional material regarding these topics, including the updated version of our detailed paper on mutual fund to ETF conversions. To help you better understand the current ETF landscape, we will be issuing several additional podcasts designed to provide a greater depth of analysis on important and timely ETF issues. If you have any questions regarding the topics we addressed or anything else, please don't hesitate to get in touch with any one of us or whomever you already have a relationship with at Ropes & Gray. You can also subscribe and listen to the series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thank you again for listening.
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