Exchange-traded funds are relentlessly gaining in popularity and increasingly eating the lunch of mutual funds, which explains the growing trend in the past couple of years among some asset managers to convert their existing equity mutual funds into ETFs. Doing so typically is a positive for investors because they’re put into a more tax-efficient vehicle that they can trade intraday. But it doesn’t always translate into success for the fund sponsor that does the conversions.

Nearly 40 mutual funds have converted into ETFs since 2021, and more are in the queue. The most active—and successful—participant in this conversion trend to date is Dimensional, according to research from Morningstar analyst Daniel Sotiroff. In a new report, he explained the factors that have made fund conversions a winning strategy for Dimensional, and why other firms might lack those advantages.

Sotiroff noted that equity mutual funds geared toward tax-sensitive investors are logical conversion candidates because the chief benefit of ETFs is their potential to reduce or eliminate capital gains distributions and the taxes that come with that.

Another factor that may or may not make a conversion a strategic fit relates to how mutual fund complexes sell their products. Funds sold via third-party platforms charge 12b-1 fees to cover their marketing, distribution and shareholder services costs.

“Mutual funds that rely on 12b-1 fees to reach investors aren’t likely to be among those switching to the ETF format because that established network of providers is incentivized to keep it in the mutual fund structure,” Sotiroff wrote.

Dimensional converted seven mutual funds between mid-2021 and mid-2022 with combined assets under management exceeding $44 billion at the time of conversion. All seven were lower-cost, tax-managed mutual funds aimed at taxable accounts, so the conversions made sense strategically.

In addition, Sotiroff noted, Dimensional reaches investors through its close network of financial advisors and institutions, obviating the need to charge 12b-1 fees. As a result, when it converted its funds it didn’t have to worry about losing fees that it didn’t charge in the first place.

“Given this unique set of circumstances, Dimensional’s seven mutual funds were ideal candidates,” he wrote.

But not all companies that charge 12b-1 fees are dissuaded from converting their mutual funds into ETFs. Sotiroff highlighted J.P. Morgan Asset Management, which converted four funds last year with total assets of more than $8 billion. All four charged 12b-1 fees that were eliminated after they became ETFs.

Three Options

ETFs have long been the domain of passively managed, index-tracking funds, but active equity managers previously known for their mutual funds have made inroads into the space in recent years. Some, like J.P. Morgan, Capital Group and Davis Funds, entered the ETF fray with fully transparent portfolios that are published daily (the standard practice for ETFs).

These strategies generally offer the same processes and managers—and similar portfolios—as their mutual fund counterparts, but with lower fees. The goal is to reach a wider audience for a sponsor’s products because mutual funds are a better fit for some investors while ETFs are preferable for others. Fund sponsors say that offering similar strategies in both mutual funds and ETFs gives financial advisors more flexibility in serving their clients.

Other asset managers, such as Fidelity Investments and T. Rowe Price, created active equity ETFs that employ semi-transparent structures enabling them to report their holdings less frequently (typically on a quarterly basis that’s the norm for mutual funds).

A third option is converting existing mutual funds into ETFs. As Sotiroff said in his report, ditching the mutual fund format for the tax efficiency and broad accessibility of an ETF sounds like a great way to attract new investors. But data shows it’s not a surefire way to gain more assets.

He noted that Morningstar Direct has tracked the net flows for 38 of the 39 funds that have converted, doing so on a cumulative basis from their respective conversion dates through the end of February 2023. The tally shows that Dimensional’s seven ETFs led the pack by collectively garnering a little less than $11 billion. Indeed, Dimensional’s funds occupied all top seven spots on the list.

The other funds in the top 10 were the Kovitz Core Equity ETF (EQTY), Neuberger Berman Commodity Strategy ETF (NBCM) and Adaptive Alpha Opportunities ETF (AGOX). In aggregate, according to the report, the remaining 28 funds lost about $1 billion.

“Some in the “All Others” category might have modest inflows or outflows, but it added up to about $1 billion in outflows,” Sotiroff said in an interview.

A Win For Investors

He then cited a couple possible reasons why fund conversions have been a mixed bag for asset managers. For starters, the ETF landscape is very competitive and performance dependent.

“Most active managers don’t do well over long time periods, so if you charge a higher fee and your track record isn’t great, the fund won’t look attractive,” he offered.

Also, he added, ETFs’ ability to trade intraday makes it easier for investors to jump ship if they’re dissatisfied with a particular fund.

“You no longer need to go to the mutual fund company to make a trade at the end of the trading day,” Sotiroff said. “You can trade all day long with an ETF.”

Ultimately, he posits, the conversion trend is a winner for investors. They might be asked to approve or disapprove the conversion in a shareholder vote. And if it goes through, they’ll need a brokerage account—if they don’t have one already—to hold the ETF. Other than that, the onus of the conversion process rests with the fund companies.

“You’re getting a more tax-efficient vehicle at the end of the day,” Sotiroff said, noting that’s especially true for equity funds. Fixed income, he pointed out, tends to be less tax-inefficient because most of their returns come from income that gets taxed whether or not the fixed-income investments reside within the ETF structure.

“If you’re in an equity fund and it converts, it’s largely all upside for you,” he said.

The fund conversion trend is primed for more growth. According to Sotiroff, roughly 20 additional mutual funds have declared their intention to transform into ETFs later this year. That includes products from the likes of Fidelity, J.P. Morgan and Franklin Templeton.