2021 may finally be the year a Mutual Fund to ETF conversion is executed, following planned conversion announcements from Guinness Atkinson and Dimensional Funds last year. Why now, and what options are available to asset managers when considering a conversion?

Brian McCabe: As for “why now,” the main reason is that the ETF Rule was finally approved in 2019, and so the path to launching ETFs has become easier and less uncertain. In addition, the SEC approval and subsequent launch of active, semi-transparent ETFs prompted many new sponsors to enter the ETF market, and converting existing mutual funds to ETFs may offer an appealing way for sponsors to enter the market with scale and a performance track record.

As for the options for conversion, the transformation from a mutual fund to an ETF can be effected through a direct conversion or a merger. In a direct conversion, the mutual fund converts into an ETF by changing its charter and offering documents. In a merger, the mutual fund merges into a shell ETF created to effect the transaction. In either case, the ETF must have an SEC exemptive order (a semi-transparent active ETF) or must operate pursuant to the ETF Rule (a traditional ETF).

With the addition of Mutual Fund to ETF conversions, the active ETF market offers asset managers a lot of choice for product design and market entry. What are some of the key considerations that Ropes & Gray advises clients on when they are assessing a conversion?

Ed Baer: One of the first things to consider is the kind of ETF you want. If the sponsor is willing to make an ETF’s portfolio holdings publicly available daily, the ETF can rely on the ETF Rule, which provides substantial flexibility in product design. Transparent ETFs can invest in a variety of asset classes, including equity and fixed income and U.S. and non-U.S. securities, and can also use custom creation and redemption baskets.

If the ETF sponsor needs to shield the ETF’s holdings, the sponsor will need to obtain and rely on SEC exemptive relief. However, this relief has a significant limitation in that an ETF operating under this relief 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. These ETFs also cannot borrow money or hold short positions. Active managers that need more flexibility and fixed income managers are limited to transparent ETFs for the time being.

One of the common questions we receive from issuers is whether prior performance track record can carry over and, if so, what happens if the fund has multiple share classes with different inception dates. What guidance can Ropes & Gray provide?

Jeremy Smith: Each ETF will need to consider its own circumstances, but most mutual funds converted into an ETF (or a mutual fund merged into a shell ETF with no performance history of its own) should be able to continue to use the converting mutual fund’s performance history. After the conversion, the ETF should consider whether to disclose the potential effects of strategy or operational changes effected as part of the conversion on the relevance of the historical performance information shown. Further, because ETFs often present performance based both on NAV and market price, the ETF may include disclosure to the effect that the prior performance was based on the NAV per share of the mutual fund shares rather than on market-determined prices.

For mutual funds with multiple share classes, the classes may need to be consolidated into a single class prior to the conversion. In a merger, the terms of the merger agreements can include provisions that give mutual fund shareholders of each class a number of shares of the ETF that correspond to the NAV of their shares as of the conversion. Those ETFs that can carry over the predecessor mutual fund’s performance history should be able to utilize the performance history of the mutual fund’s oldest share class.

Another question we hear regularly from issuers is: will a Mutual Fund to ETF conversion have tax consequences for existing shareholders?

Brian McCabe: The conversion of a mutual fund to an ETF should not have any significant negative tax consequences to the mutual fund, the ETF, or their shareholders. There are generally ongoing tax benefits to operating as an ETF rather than as a mutual fund – this is one of the key reasons a sponsor might want to consider converting mutual funds with significant unrealized capital gains into ETFs, and one large mutual fund manager has announced its intention to convert a number of tax-managed mutual funds into ETFs during 2021. 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. In addition, any disposition of securities prior to the conversion 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 distributed to shareholders in taxable distributions.

What are some of the often-overlooked considerations that Ropes & Gray advises clients that are evaluating a conversion?

Ed Baer: The board of the ETF will need to understand the structural differences between mutual funds and ETFs, especially the arbitrage mechanism, as well as the implications of the conversion for shareholders. One key issue is 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. In addition, sponsors should work closely with their service providers and intermediaries to ensure a smooth transition. Because the distribution models for mutual funds and ETFs differ significantly, sponsors should engage with their distribution partners. This may involve hiring an ETF capital markets specialist to engage with APs, market makers, exchanges 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. In addition, it will be necessary to establish a creation and redemption infrastructure for the ETFs, including preparing AP agreements, creation/redemption order guidelines, and basket construction policies, potentially including custom basket transactions.

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