Mutual fund conversions to ETFs present difficulties, Deloitte believes

Conversions from mutual funds to ETFs have become a way for asset managers to reshape investment offerings for investors, but they can be long and difficult processes, a new study has found.

Operational risks such as constraints and logistical issues pose challenges for asset managers looking to convert mutual funds, according to Deloitte’s recently released Investment Management Outlook 2025.

These obstacles include brokerage account requirements, distribution channel arrangements and fractional share management issues, the report said.

There were a total of 119 conversions, according to data from Morningstar.

This article was previously published by Ignites, a title owned by FT Group.

The first, led by Guinness Atkinson in 2021, was initially seen as a revolutionary development that would spur the industry’s move toward ETFs and away from mutual funds, said Alex Alberstadt, counsel in the investment management group for Seward & Kissel, LLP. , who worked on the conversion.

“At the time, they were seen as a clean process. It felt like there weren’t all these bells and whistles and extra layers of cost,” Alberstadt said.

However, “there are operational issues that everyone needs to be up front about, and when you’re planning a conversion, you have to manage those issues,” she said.

More than $60 billion in assets have been converted from mutual funds to ETFs, according to the Deloitte report.

Firms such as Dimensional Fund Advisors, Fidelity and JPMorgan dominated conversion flows through April, Morningstar data shows.

A DFA spokesman declined to comment when contacted.

Fidelity recently filed to convert two municipal bond funds into ETFs next year, according to regulatory filings. Once the conversions are complete, Fidelity will have completed 14 in total, according to Morningstar data.

“Fidelity believes the conversions will provide several benefits to the fund’s investors, including lower expenses, additional trading flexibility and increased portfolio transparency,” the manager said in a Q&A about the conversions posted on its website last week.

A spokesman for the manager did not respond to a request for comment on the operational hurdles it faced in the conversion process.

But analysts agree with Deloitte’s findings.

“There’s a lot of work behind the scenes to make these conversions go smoothly. . . If you’re going to do it, it’s got to be done right so your customers have a seamless experience,” said Morningstar analyst Dan Sotiroff.

“Conversion is usually for smaller funds and can be a distribution strategy as much as a marketing strategy. Companies can use them as a way to get streams, but that doesn’t necessarily happen,” Sotiroff said.

As of Sept. 30, year-to-date net flows into mutual funds converted to ETFs totaled about $11.2 billion in assets, according to Morningstar data.

And because clients need access to brokerage accounts to hold ETFs, conversions can be problematic for firms whose clients don’t use them. These can include clients’ 401(k) plans that don’t typically use ETFs, according to Sotiroff.

“At a high level, you need to make sure your clients can own ETFs — and that’s just the beginning,” Sotiroff said.

Fractional shares are also problematic because they are available to mutual funds but not to ETFs.

Fractional mutual fund shares must be redeemed at the strategy’s net asset value during a fund conversion, but timing is a factor, Alberstadt said.

Because ETFs do not issue fractional shares, mutual fund shareholders who wish to redeem before conversion may incur additional fees when those shares are sold.

That information needs to be communicated to customers and service providers in a concise manner, Alberstadt said.

“The fractional action issues must all be planned. There are more intermediaries at the table and it requires resources and attention,” she explained.

Firms must publish an analysis of the transaction and ensure that the process was handled properly, she said.

Some of the operational challenges of the conversions could be alleviated by regulatory approval of the two-stock fund structure that has long been patented by Vanguard, Albertstadt and Sotiroff both said.

An ETF share-class option would be a conversion-friendly alternative, Karin Risi, Vanguard’s managing director of corporate strategy, product, marketing and communications, said during a panel discussion at the Financial Times Future of Asset Management conference in New York.

The conference was co-sponsored by Ignites.

“If you have the opportunity for multiple share classes, you don’t have to go through the much more cumbersome and operationally intensive process of converting a mutual fund,” Risi said. “Adding an ETF share class to a fund is a cleaner process.”

*Ignites is a news service published by FT Specialist for professionals working in the asset management industry. Trials and subscriptions are available at ignite.com.