Mutual Funds Transitioning to ETFs

Market analysts are observing a notable trend where asset managers are increasingly launching mutual fund strategies as exchange-traded funds (ETFs). This shift capitalizes on the popularity of ETFs in recent years, benefiting many individual investors.

There are various strategies at play here. One approach involves converting mutual funds into ETFs. According to data from Morningstar, there were 56 mutual funds converted to ETFs in 2024, up from just 15 in 2021, with an additional 40 conversions in the current year.

Another strategy some firms adopt is creating ETF “clones” of specific mutual funds. This allows investors the option to choose between a traditional mutual fund or an ETF version of the same strategy.

Growing Interest in ETFs

Furthermore, more than 80 asset managers have sought approval from the Securities and Exchange Commission to introduce ETF share classes for their existing mutual fund portfolios, according to Brian Armor, director of North American ETF and passive strategies research at Morningstar. This approach differs slightly from the aforementioned methods, as it treats the ETF as a separate share class sharing the same portfolio as the mutual fund.

Armor describes this trend as one of the most significant in the fund market today, expressing an expectation that several ETF stock classes will experience heavy usage over the next couple of years. The first application for this from Dimensional Fund Advisors is set for September 29th. Armor noted that they are in a waiting phase for further approvals by the SEC, which may be influenced by potential government shutdowns.

Investor Preferences and Tax Benefits

ETFs and mutual funds function as baskets of stocks, bonds, and other assets managed by professionals, helping investors diversify. Recently, there’s been a marked shift in investor preference towards ETFs. Morningstar reports that approximately $1.1 trillion is projected to flow into U.S. ETFs in 2024, a record high, while mutual funds saw a withdrawal of about $388 billion.

While ETFs account for around one-third of the total U.S. fund market, their share is rising steadily. For instance, ETFs held a 14% market share compared to mutual funds at the end of 2014, which was only 5% in 2004.

The appeal of ETFs largely stems from their distinct advantages. Financial advisors argue that ETFs are generally more beneficial for individual investors due to their tax efficiency and lower annual fees in comparison to mutual funds, according to Blake Pignan, a certified financial planner at Anchor Bay Capital.

Armor also pointed out that investors benefit from greater transparency regarding ETF holdings, as these are disclosed daily, unlike mutual funds which typically reveal holdings monthly or quarterly. “ETFs have gained significant traction in the market,” he added, suggesting asset managers are keen to meet the rising demand.

Choosing Between ETFs and Investment Trusts

Pignan remarked that for those holding taxable brokerage accounts, it’s generally advisable to prefer ETFs for tax efficiency. He cautions against mutual funds in taxable accounts due to their potential tax inefficiencies. However, experts also highlight that ETFs aren’t automatically superior; their tax benefits don’t apply within tax-advantaged accounts like IRAs or 401(k)s.

Investors should also consider whether ETF clones of actively managed mutual funds are true “identical twins” or just “cousins.” According to Greg Wolper, a senior manager research analyst at Morningstar, cousin ETFs may share similarities with mutual funds from the same manager, but they aren’t identical and may not suit every investor’s needs.

A potential downside for ETF investors could emerge if the SEC approves further applications for mutual funds with ETF stock classes. This could lead to shared tax burdens and diminish some of the tax advantages typically enjoyed by ETF investors. Nonetheless, such scenarios are expected to be infrequent. According to a report from Morningstar, “In certain circumstances, caused by mutual fund investor actions, ETF share classes might face capital gain distributions.”