Why are some mutual funds changing into exchange-traded funds?

ETFs often have lower costs and result in lower tax bills than mutual funds

In the contest between mutual funds and exchange-traded funds, investors have been voting with their wallets lately for ETFs. Now at least three fund issuers intend to convert some of their mutual funds to ETFs.

ETFs can be traded all day like stocks as their prices rise and fall. They often have lower costs and result in lower tax bills than mutual funds do.

But mutual funds, which are priced only once a day, may be more stable in some respects. During a two-week period in March when the markets became volatile, bond ETFs traded at huge discounts to their net asset value, or NAV, which is the per-share value of the fund’s holdings. That means that if you wanted to sell your fund in the middle of the turmoil, you would have faced even steeper losses than the market decline warranted.

Bond ETFs usually trade at prices close to the NAV, but during the so-called pandemic panic, some major bond ETFs traded at discounts of 7% or more before recovering in April. Partly because of mutual funds’ once-a-day pricing, their investors didn’t face the same problems.

Dimensional Fund Advisors of Austin, Texas, filed to convert four tax-managed mutual funds and two core mutual funds to ETFs in November, a move the firm projects will cut management fees as much as 0.15%. Guinness Atkinson Asset Management, which is based in Milwaukee, plans to convert several funds, as does Nottingham Co., a Rocky Mount, North Carolina, fund administrator.

Read | Gold-backed ETFs end record 2020 with second month of outflows

Dimensional Fund Advisors doesn’t expect to convert any additional mutual funds, said Marlena Lee, global head of investment solutions for the company. “Because we want to provide our clients choices in how they invest with us, we intend to have a full lineup of both mutual funds and ETFs,” Lee said.

Investors can also turn to other mutual fund companies, like Vanguard, that offer ETF versions of some of their mutual funds.

While mutual funds still dwarf ETFs, with $22.5 trillion in assets compared with $4.7 trillion for ETFs, the recent trend has favoured exchange-traded funds. ETFs posted total inflows of more than $509 billion during 2020, according to Elya Schwartzman of ES Investment Consulting in Marin County, California. Schwartzman projected that mutual funds took in just $209 billion during the year. That includes $679 billion that flowed into money market mutual funds, seeking a safe haven.

Without the money market inflows, long-term mutual funds lost $470 billion in outflows for the year. Only 32% of mutual fund issuers posted net inflows of cash in 2019, compared with 74% for ETFs, according to the Investment Company Institute, a trade group.

ETF managers point to several specific benefits of exchange-traded funds compared with traditional mutual funds. They include greater transparency in holdings and lower operating costs. And because of the way mutual funds are structured, investors can find themselves owing capital gains taxes at the end of the year, even if they didn’t redeem shares and even if the share price ended the year with a loss, a surprise that is unlikely for ETF shareholders, who pay capital gains only when they sell the fund at a profit.

Another advantage cited by Jim Atkinson, chief executive of Guinness Atkinson Asset Management, is the ability to trade ETFs during the day.

“With mutual funds, you don’t know the real price,” Atkinson said. “With an ETF, you can put a market order in and know what the price is. A lot of advisers don’t like putting their clients in a position where they don’t know the price until the end of the day.”

Guinness Atkinson has been working on converting these funds since mid-2018. That included negotiating with regulators and contacting shareholders.

The conversion process is complex. Fund managers will usually start a shell ETF, then merge the existing mutual fund into the new ETF. That will save shareholders of the converted mutual funds from paying taxes because of the change.

Unlike many ETFs that mimic established indexes — like the S&P 500 — these converted funds will continue to be actively managed along the lines of the mutual funds they replace.

“I think it’s a great thing for investors, and longer term it’s going to be a good thing for outfits making this change,” said Andy Kapyrin, partner and co-head of investments at RegentAtlantic, a Morristown, New Jersey, wealth manager. “Mutual funds were revolutionary, but ETFs are just a better, newer technology.”

But Kenny Polcari, managing partner of Kace Capital Advisors in Boca Raton, Florida, doesn’t see a lot of advantages for ETFs. For example, Polcari prefers the relative opacity of mutual funds and their quarterly reporting of their holdings because that less frequent disclosure prevents investors from engaging in spot trading based on what the fund buys or sells.

“The managers claim that these are actively managed funds, and they could be more actively managed than current ETFs, but I prefer a mutual fund with more of a long-term approach,” Polcari said. “I don’t think it’s the next investment vehicle everyone will flock to. It sounds sexy, but I wouldn’t go into an actively managed ETF.”

Fund managers say they’ve been fielding requests from their clients for years to add ETFs that they can use to build custom portfolios for their investors. The Securities and Exchange Commission approved new rules for ETFs that went into effect in December, eliminating a lengthy and expensive approval process for new funds and allowing new potential tax benefits for companies issuing ETFs.