In a world where the cost of everything seems to be rising painfully, here's a little good news for investors: A growing number of mutual funds are converting to exchange-traded funds (ETFs) and cutting their fees.
More than 60 mutual funds, managing a combined $55 billion, have turned themselves into ETFs in the two years since this trend started, according to data provided by FactSet Research Systems. Recently converted ETFs include Dimensional U.S. Core Equity 2 (DFAC), which has more than $20 billion in assets; JPMorgan International Research Enhanced Equity (JIRE), with more than $5 billion;Fidelity Enhanced Large Cap Value ETF (FELV) with $1.8 billion,and Fidelity Disruptive Automation (FBOT), with more than $100 million.
On average, the converted ETFs are charging investors fees that are almost a quarter of a percentage point less than they charged as mutual funds, according to FactSet. An investor with $10,000 in a typical newly converted fund is saving $24 a year. And most of the conversions are structured to be tax-free for most investors.
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Mutual fund to ETF conversions are a growing trend
Although a few dozen funds make up a tiny percentage of the more than 8,700 mutual funds currently operating in the U.S., more conversions are coming. At least 16 additional funds, accounting for more than $15 billion in assets, have already announced plans to convert in the next few months.
Among those slated for conversion are Morgan Stanley's Short Duration Municipal Income Portfolio (MUIMX), with nearly $190 million in assets; and the Franklin Focused Growth Fund (FFQZX), with almost $95 million.
Even more conversions will likely be announced in 2024, especially by actively managed and higher-fee mutual funds looking to attract more investors by providing the lower costs and easier access that ETFs offer, says Aniket Ullal, head of ETF data and analytics for CFRA Research.
Asset managers are taking advantage of a 2019 Securities and Exchange Commission (SEC) rule change that allowed such conversions so funds could adapt to changing investor preferences. Investors have been generally transferring money out of mutual funds and into ETFs since 2015.
The trend, Ullal believes, is beneficial. "The conversions are going to continue, and this is positive for investors," he says.
In addition to lower fees, ETFs offer investors tax savings. Unlike mutual funds, ETFs are structured so they don't have to sell holdings and thus record capital gains when investors pull money out. ETFs, which are traded like stocks, can also be sold throughout the trading day, unlike mutual funds. And ETFs offer investors more transparency, because most ETFs publish their holdings every day, whereas mutual funds only publish once a quarter.
How investors can take advantage of this conversion trend
Of course, there's no such thing as a totally free lunch. Conversions can cause a few hassles or financial headaches for some investors. Our three-point checklist will help you take advantage of the conversion trend and get the best portfolio for your needs:
Know your account rules. Most investors hold their mutual funds in accounts at brokerage firms (whether tax-deferred retirement accounts or taxable accounts) or in 401(k) retirement plans. In these cases, investors don't have to pay extra taxes when a mutual fund they own converts to an ETF. Brokerage account holders simply get the value of their mutual fund investment transferred tax-free into the ETF version. The new ETF has the same managers and portfolio that the mutual fund had. If you were happy with your mutual fund, you don't have to take any action in response to the conversion.
The only possible hassle for taxable brokerage account fund holders is a small one: Mutual funds allow you to invest in dollar amounts, while ETFs are sold like stocks and so have share prices. Some brokerages will only allow you to invest in ETFs in whole shares. If you have $1,000 in a mutual fund that converts to an ETF selling for, say, $90 a share, you might get 11 ETF shares and $10 in cash. Any profit on that small amount could be counted as a capital gain at tax time.
Because 401(k)s are tax-advantaged, conversions don't trigger additional taxes for their account holders. If, like many 401(k) plans, yours doesn't hold ETFs, the fiduciaries who manage employer-sponsored retirement accounts are supposed to help you switch to another good mutual fund option, notes Jeff Naylor, the Investment Company Institute's chief industry operations officer.
There's a third type of account. Some investors invest directly with mutual fund providers using a mutual fund-only account, and they could face hassles and higher taxes. If a fund held in one of these accounts converts to an ETF, you'll get cash instead. And you will probably want to find another mutual fund to keep yourself fully invested. More problematic: If your mutual fund-only account is taxable, you could face capital gains tax liabilities. A simple solution is to open a free brokerage account and transfer the affected mutual fund shares into it prior to the conversion date.
Check your settings. One advantage of mutual funds is that they make it easy to automatically reinvest dividends. Reinvestment is not generally automatic for ETFs held in brokerage accounts, however, so you'll need to check your account settings to make sure your broker is following your wishes for any dividend distributions. In many cases, it's just a matter of clicking on a box in a web form.
Assess the probabilities. Are your funds likely candidates for conversion? The mutual funds most likely to be converted tend to be actively managed or aimed at investors using taxable accounts, says Bryan Armour, who heads research into index funds and ETFs for Morningstar. Among the likely prospects are funds that promote tax advantages, such as municipal bond funds and stock funds that avoid dividends and stock sales, he says.
Those least likely to be converted are low-cost index funds, retirement-focused investments such as target-date funds, and specialized funds such as small-company funds that would have trouble managing rapidly changing asset levels.
If your mutual fund's expenses or tax liabilities are high, but a conversion is not on the immediate horizon, you can switch to a similar ETF yourself. Many fund companies now offer ETF "clones," or copies of their popular mutual fund portfolios. (Remember, though, that cashing out of mutual funds in taxable accounts could raise your capital gains liability for the year.)
Alternatively, check whether your fund company currently offers, or is on track to launch, an ETF share class of your fund. Currently, only Vanguard offers ETFs that are considered a share class of an established mutual fund. But several other funds, including Dimensional, have applied to the SEC for permission to follow suit.
Regardless of how these conversions are completed, it's clear that more are coming. If you're a fund investor who hasn't jumped on the exchange-traded bandwagon yet, your mutual fund might soon give you a nudge.
Note: This item first appeared in Kiplinger's Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
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