- The ability to convert mutual funds into ETFs could greatly facilitate an asset manager’s goal to enter the ETF business.
- Asset managers can take advantage of the new non-transparent, actively managed ETF to convert actively managed mutual funds.
- Certain issues still need to be resolved before the first mutual fund to ETF conversion takes place.
Asset managers are exploring the idea of converting mutual funds into exchange-traded funds (ETFs). This comes at a time when the Securities and Exchange Commission (SEC) has allowed the first non-transparent, actively managed ETF, which enables asset managers to offer their actively managed strategies in an ETF product without divulging the “secret sauce” behind them. This combination of regulatory developments could pave the way for mutual fund complexes to transform some or all of their mutual funds into non-transparent, actively managed ETFs. Asset managers of actively managed mutual funds less sensitive about daily disclosing their investment portfolios could convert those funds into traditional, fully transparent ETFs.
To date, no mutual fund has been converted into an ETF. Such a conversion raises regulatory and operational issues, none of which are insurmountable. In this publication, we discuss the issues and steps that asset managers and their counsel need to consider in converting a mutual fund into an ETF.
Create a Realistic Timetable for Conversion
Asset managers should begin to consider whether converting mutual funds to ETFs makes sense, recognizing that regulatory obstacles must first be cleared before the first conversion may take place. Asset managers considering mutual fund to ETF conversions should understand that such conversions have not been sanctioned by regulators and it may take some time for the SEC, aided by their counsel and service providers, to work through and solve the issues raised by such conversions. The SEC staff has been only recently made aware of certain asset managers’ desire to convert their mutual funds to ETFs. At this stage, the industry and SEC staff are inventorying the issues and beginning the early stages of analysis. No firm to our knowledge has filed any regulatory documents to effect such conversions. While the SEC has allowed conversions of closed-end funds to ETFs and Canadian regulators have allowed mutual funds to convert to ETFs, there is no assurance that the agency will make available this option to mutual funds or that it will not impose overly burdensome conditions. With that said, the SEC staff has signaled a willingness to examine how mutual funds can be converted to ETFs under current regulations. It is therefore not premature for fund complexes interested in conversions to begin analyzing their fund line-ups, particularly focusing on what mutual funds might have investment strategies and investment portfolios most suited for an ETF. Assuming the industry obtains a regulatory green light, asset managers should anticipate a timeline of several months to accomplish a conversion.
Establish Brokerage Accounts for Shareholders
An asset manager, working with its counsel and other service providers, will have to effect the exchange of the shares of the mutual fund held by its existing shareholders in accounts at the mutual fund’s transfer agent for shares of the ETF that must be maintained in accounts at broker-dealers. Since the asset manager knows the identities of shareholders of who hold their shares at the mutual fund’s transfer agent, it might be able to facilitate the transfer by directing such shareholders to set up brokerage accounts at an affiliated or unaffiliated broker-dealer, cancel the mutual fund shares from the shareholder’s account at the transfer agent and deliver shares with the same value to an account established in the shareholder’s name at the brokerdealer. It would need the cooperation of the broker-dealer sponsor of a platform to accomplish the same task with respect to shareholders who own mutual fund shares through an omnibus arrangement. From an operational standpoint, it may be a challenge to program mutual fund transfer agent systems to interface with brokerage systems. It will also be necessary to communicate how the conversion will be effected to The Depository Trust & Clearing Corporation (DTCC) and address any issues raised by DTCC. A vexing issue is that some action needs to be taken by a shareholder to open a brokerage account and the shareholder may do nothing, even if given the option to do so by the mutual fund’s transfer agent. In the case of shares held in an omnibus account, the current distribution arrangement with the platform sponsor may need to be unwound and renegotiated and such sponsor may seek some economic incentive to assist with the conversion. There may be other solutions or necessary steps, such as providing shareholders with notice that if they do not set up a brokerage account, their shares will be redeemed for cash prior to the conversion or their new ETF shares will be held in their name in another account pending their instructions. Complicating this process is the fact that mutual fund shares are held in a number of types of accounts, including IRA and retirement plans. ERISA and other applicable law will have to be carefully examined to address any legal issues associated with converting these accounts, which likely will involve consultation with the person or entity responsible for such accounts (e.g., the plan fiduciary).
Select the Type of Conversion
An asset manager will have to decide what type of conversion is preferable: a direct conversion of the mutual fund into an ETF or the reorganization of the mutual fund into a newly established ETF entity or shell. Both mutual funds and ETFs typically are series of a trust or corporation. The most straightforward and appealing approach to conversion is to simply change or redesignate the mutual fund series into an ETF series. While simple in concept, such a direct conversion may be more complex from a legal standpoint. The firm will have to examine whether the trust’s governance documents would allow such a conversion. In addition, the state law that governs the trust or company may not expressly allow such conversions or be ambiguous on this issue. On the flip side, reorganizing the mutual fund series into a newly created ETF series requires more steps but arguably would be simpler in terms of legal issues. A trust may have both mutual fund and ETF series and the conversion would merely involve the mutual fund series’ assets being transferred to the newly created ETF series in the same trust or company in exchange for ETF shares that would be distributed to the mutual fund series’ shareholders. It should be noted that an asset manager may desire to convert a mutual fund into an existing ETF with a portfolio of securities, which also would require a reorganization. Individual circumstances may have a significant impact on selecting the type of conversion, and obtaining advice can be important.
Obtain Shareholder Vote or Conclude that Such Vote Is Not Required
An asset manager may have to obtain approval from the shareholders to convert the mutual fund to an ETF. Whether or not a shareholder vote is required to effect a conversion is a question that first requires the consideration of the type of conversion: a direct conversion or a reorganization. With respect to the former, a direct conversion does not require a transaction. However, the rights of a shareholder who once held shares of a mutual fund and after the direct conversion holds shares of an ETF would change. This is because mutual fund shares and ETF shares have different rights attached to them. For example, a mutual fund shareholder has the right to redeem his or her shares directly from the issuer for cash (or in some cases, a pro rata share of the portfolio securities the mutual fund owns); an ETF shareholder does not have such a redemption right (unless the shareholder is an Authorized Participant) but does have the right to sell his or her shares on an exchange (a right the mutual fund shareholder does not have). Consequently, whether or not a shareholder vote is necessary may turn on whether the ETF share issued is a new security with different rights. Shareholder vote may also be required if a mutual fund is reorganized into an ETF. Under Rule 17a-8 under the Investment Company Act of 1940 (1940 Act), the shareholders of the acquired fund (in this case, the mutual fund) must vote to approve a fund reorganization unless: the mutual fund and ETF share the same adviser, investment objectives, principal policies and risks, the distribution fees will remain the same (or be lower), and a majority of the disinterested directors of the acquiring fund are persons who were elected disinterested directors of the acquired fund. While this is feasible, the SEC staff has not taken a position regarding whether a mutual fund may be reorganized into an ETF without shareholder vote in reliance upon Rule 17a-8. If that rule is deemed available, the asset manager nevertheless should consider sending an informational statement to the mutual fund shareholders disclosing information about the reorganization. Additionally, a mutual fund’s governing documents and the applicable state statutory requirements should be reviewed and analyzed to determine whether the mutual fund’s shareholders need to approve the reorganization at a shareholder meeting. If a shareholder vote is required, the direct conversion and reorganization would have to be voted upon in compliance with the SEC’s proxy rules and registration rules, including the preparation and filing of the appropriate SEC forms (i.e., Schedules 14A and N-14).
The mutual fund shareholders will have to be notified about the upcoming conversion. Irrespective of whether a shareholder vote is necessary, shareholders would have to receive ample notice of the conversion. At a minimum, shareholders likely should be notified at least 30 days prior to the conversion. A longer notice period with additional disclosure may be necessary, depending on how brokerage accounts would be set up to effect the conversion, which is discussed above. Notice involves “stickering” the mutual fund’s prospectus and Statement of Additional Information and posting information on the mutual fund’s website.