What is your ETF strategy?

ETFs saw nearly $975 billion in global inflows in 2023, serving as the preferred vehicle for indexed strategies.⁴ With all the market volatility over the past several years, the pricing, tax, and liquidity advantages of ETFs have led to an expansion of their use, while placing competitive pressure across the industry. ETFs have an edge in terms of tax efficiency due to their in-kind creation and redemption capability. This feature is more beneficial for ETFs with frequent trades, strategic beta, or concentrated active funds. Actively managed ETFs are growing in prevalence, as traditionally active managers grow increasingly comfortable with newer transparency rules and seek to open new distribution opportunities. In Europe, active ETFs rapidly grew their market share by 125% in 2023.⁵ A healthy slate of mutual-fund-to-ETF conversions contributed to the significant growth of US actively managed ETFs in 2023, with 36 mutual funds converting to ETFs in the United States during the year.⁶

Many investment management firms are seeking to meet this demand for actively managed portfolios within an ETF wrapper. ETFs are growing in popularity in Europe likely due to their low costs and speed to market. In the United States, as of December 31, 2023, 34 of the top 50 investment managers had entered the active ETF market—16 since 2021⁷—signaling interest and optimism are high. Here we explore three paths to help make a strategic play in the ETF market.

Old-fashioned ETF launch

For investment managers yet to enter the ETF market there are various matters to consider in executing an ETF strategy. If the choice is to launch a new ETF, one difference between a mutual fund and ETF relates to disclosure of portfolio holdings on a daily basis, and whether to shield their ETF portfolio holdings through the semi-transparent active wrapper, which would require US Securities and Exchange Commission (SEC) exemptive relief. The selection of third-party service providers will generally be a critical part of the launch decision, including the distributor, custodian, transfer agent, Authorized Participants (APs), and legal and audit firms. One area that takes time to get right is the basket creation and redemption process done by the front-office team, which is consistently highlighted by investment managers as one of the most time-intensive processes in launching an ETF. This will likely involve developing relationships with APs and market makers, executing AP agreements, and establishing creation/redemption order guidelines. A fresh look at compliance processes will also be warranted as changes to existing fund policies should be evaluated and expanded, including ETF basket construction policies. Launching new ETFs reaches the widest audience of the three paths mentioned in this article, and offers similar processes, managers, and portfolios as their mutual fund counterparts but with potentially lower fees, making this the preferred path for entering the ETF market globally.

Tax “efficiency” is often considered a key benefit of an ETF in the United States. Much of the tax efficiency from the ETF comes from the ability to utilize “in kind” redemptions to defer the recognition of gain by the ETF shareholder. For ETFs that register with the SEC under the Investment Company Act of 1940 and elect to be taxed as a regulated investment company (RIC), the ETF can avoid recognizing gains on appreciated securities that are distributed to the APs in exchange for redeeming shares of the ETF. Since the gains are not recognized for tax purposes at the ETF level, they are also not distributed to the shareholders. As such, shareholders can avoid recognizing the gain on those appreciated securities until they ultimately dispose of their investment in the ETF.

Convert a mutual fund to an ETF

Since March 2021, more than $60 billion in mutual funds have converted to ETFs in the United States.⁸ The conversion path has a number of advantages, including the ability to retain the fund’s performance track record and brand recognition, lower operational costs, and more tax efficiency than a mutual fund. There are some potential challenges to consider, including that mutual funds that are widely used in 401(k) plans may not be a good fit for an ETF conversion due to plan recordkeeper limitations associated with intraday trading, and fractional shares and ETF shares are always held in a brokerage account, which can be a logistical challenge for mutual fund shareholders. ETF conversions also present some regulatory risk as they were highlighted as an examination priority by the SEC in 2023.⁹ It is important to have good relationships with third-party service providers as they can help with conversions. Conversion of a mutual fund into an ETF is less burdensome; assuming the shareholder base and the fund holdings remain consistent. The transaction will likely qualify as a tax-free reorganization under IRC section 368(a)(1)(F) (“F reorganization”). Time will tell whether the more strategic path will be to convert mutual funds to ETFs, to launch an ETF, or to wait on SEC action to register an ETF share class of an existing mutual fund.

A new path unlocks: ETF share classes

Prior to the patent expiry in May 2023 for ETF share classes, this was not a path for investment managers. However, since then, several investment managers have applied to the SEC to establish similar structures for their existing passively managed mutual funds. The SEC has not approved ETF share classes for actively managed ETFs in the United States. Thus, the success of this path depends on positive regulatory action. This path is becoming more relevant in Europe where the cost benefits and speed to market are the primary drivers, and the headwinds there being resistance from market players involved in distribution. However, the benefits of ETFs as a share class of a mutual fund might make the wait worthwhile and lucrative, which include the following:

1. ETF share classes are exempt from the daily portfolio holdings disclosures required by ETFs, which fall under Rule 6c-11.¹⁰
2. Tax “efficiency” for both the ETF and mutual fund share classes through the use of custom baskets for in-kind redemptions (CIKRs), reducing the distributions of capital gains tax to investors. An ETF share class extends the tax benefits of CIKRs to the mutual fund share classes unlike stand-alone mutual fund products. On the other hand, cash redemptions through the mutual fund can provide tax losses that can be used to offset capital gains liabilities generated in other share classes.
   
3. The ETF share class will have the existing performance and investment strategy of the mutual fund.
   
4. Investors can convert their mutual fund shares into ETF shares of the same fund, without realizing capital gains, but they are unable to convert vice versa.
   

The expiration of the patent provides for the benefits of the ETF share class to be applied to mutual funds more broadly, and CIKRs are an important piece of realizing the tax benefits of the ETF. Firms already utilizing CIKRs should expect to review their process as mutual fund managers and supporting teams adjust for the capital markets ecosystem and ETF life cycle. Additionally, these transactions are highly manual for operational teams and involve movement of securities and cash (often in the billions of dollars for large firms), which require appropriate controls and oversight. The inclusion of mutual fund holdings in these already large and manual transactions increases risk and requires appropriate controls and oversight across the ETF operational process.

Although the ETF share class may create a beneficial tax environment, it is possible for tax liabilities to be passed to ETF investors if the mutual fund realizes significant capital gains, and conditions could affect the ability of the ETF share class to remove the capital gains. For firms experienced with ETFs or those looking to launch their first ETF, an ETF share class provides a potential opportunity to expand the product offering while benefitting both ETF investors and mutual fund share class investors through decreased costs and taxes.