Some mutual funds have announced plans to convert to ETFs. ETFs are similar to mutual funds. They both are pooled investment vehicles that invest in a variety of investments, but they are structured differently. The Office of Investor Education and Advocacy is issuing this Investor Bulletin to educate investors about certain considerations in connection with these conversions.
How do I know if my mutual fund plans to convert into an ETF?
If you own shares of a mutual fund that plans to convert into an ETF, the mutual fund will notify you. In many instances you will receive a document that contains information about the differences between your current mutual fund and the new ETF, and it will discuss the principal risks associated with the ETF. It will also let you know if shareholder approval is required for the conversion and, if so, what you need to do to vote to approve (or not approve) the conversion.
What do I need to do if my mutual fund is going to convert?
First, understand the difference between the two types of funds and which may work better for your financial situation. You can read our investor bulletin, Characteristics of Mutual Funds and Exchange-Traded Funds (ETFs), to better understand both.
Second, choose whether to continue to own the shares after the fund converts to an ETF. Check out the considerations discussed below to help you make your decision.
If you want to continue to own the investment after it converts to an ETF:
- If your mutual fund shares are already held in a brokerage account, you will not need to do anything with your shares. They will automatically convert to shares of the new ETF.
- If your mutual fund shares are held directly with the mutual fund, you need to open a brokerage account to hold shares of the ETF.
- At the time of conversion, the value of your investment will not change as a result of the conversion.
If you don’t want to continue to own the investment after it converts to an ETF:
- Redeem your mutual fund shares back to the mutual fund before the fund converts to an ETF. You may also be given the choice to exchange your shares into another mutual fund. Each of these transactions may have tax consequences for you.
In either case, make sure you understand the timing of the conversion, and call the mutual fund’s shareholder services phone number or your financial professional if you need help understanding your options.
What should I consider if my mutual fund is converting to an ETF?
Here are some immediate considerations:
- Investment fit. Make sure the investment still fits with your financial situation and goals. The mutual fund may adjust its portfolio holdings – that is the investments it owns – when it converts to an ETF.
- Share classes. Many mutual funds have multiple share classes, but ETFs typically have only one share class. If this is the case with your mutual fund, the fund will have to consolidate its share classes before converting to an ETF. This may affect you if you want to sell your mutual fund shares before conversion and it may impact the ongoing fees you pay as part of your investment.
- Brokerage account. If you do not hold the mutual fund through a brokerage account, you will need to open or designate a brokerage account to hold the shares after the conversion and to buy and sell shares of the ETF in the future. Mutual fund shares are bought and sold through the mutual fund and often do not require you to hold the shares in a brokerage account. ETF shares are bought and sold on a national securities exchange and are required to be held through a brokerage account.
- Fractional shares. Unlike mutual funds, ETFs typically don’t issue fractional shares. If you own fractional shares of the mutual fund, they may be redeemed and converted to cash by the mutual fund before the conversion. This redemption may be treated as a taxable event, and you might owe taxes when you redeem.
- Taxes. Find out if you will otherwise owe taxes because of the conversion. Generally the conversion from a mutual fund to an ETF is structured so as not to be a taxable event to shareholders. But if the mutual fund sells investments in its portfolio prior to the conversion, it may result in a recognition of capital gains for the mutual fund which could lead to taxable distributions to shareholders. If that happens, you may owe taxes on these distributions.
Here are some considerations that are ongoing:
- Tax efficiency. Mutual fund investors holding shares in a taxable account generally have to pay taxes on any capital gain distributions they receive from the mutual fund. ETF investors may also have to pay taxes on any capital gains distributions from the ETF. However, because many ETFs buy and sell portfolio securities in in-kind exchanges (rather than for cash), they typically have fewer capital gain distributions than mutual funds and hence ETF shareholders pay less in taxes on a similar investment.
- Lower expenses. Because ETFs require somewhat different services to operate than mutual funds, ETFs have tended to be less expensive to operate than mutual funds that invest in a similar manner. ETFs pass these savings on to the investor in the form of lower total expenses. But you may pay brokerage commissions and additional trading costs when you buy and sell ETF shares.
- Reinvestment of distributions and dividends. Investors can typically automatically reinvest the distributions or dividends from mutual funds back into the fund. ETF investors may have to make these additional trades for themselves. Until you reinvest these distributions, the cash you received will not be invested. Also, you may have to pay transaction fees when you reinvest these distributions.
- Trading during the day. Unlike mutual fund shares, which are bought and redeemed through the fund, ETF shares are bought and sold on national securities exchanges. This gives investors the ability to buy or sell ETF shares throughout the day. But it also means that there is a risk that a trading market may not develop, which might make it difficult to sell your shares at their net asset value.
- Premium or Discount to NAV. Mutual funds are bought and redeemed at the net asset value (NAV) determined at the end of the trading day. ETFs are bought and sold at the current market price on a national securities exchange. This can give you some flexibility with your shares, but the market price for ETF shares may be higher or lower than the shares’ NAV. Shares that sell at a price higher than the NAV are said to be sold at a premium, and shares that sell at a price lower than the NAV are said to be sold at a discount.
- Invests more of its cash. Unlike mutual funds, ETFs are not required to buy back or redeem shares from retail shareholders. As a result, ETF managers do not have the same concerns about constant redemptions as mutual fund managers do. This may give ETF managers more flexibility to invest more of their cash.