ETF Share Classes in Mutual Funds: What to Know

In recent years, Fidelity, Dimensional, JPMorgan and Neuberger Berman have converted one or more mutual funds to an ETF share class. BlackRock, for its part, recently converted the Blackrock Dividend mutual fund to an ETF.

ETF Share Classes Explained

The asset management firm that owns the ETF purchases the securities owned by the ETF in a trust. When an investor trades shares of the ETF, the fund manager uses “creation units” from the underlying trust to handle inflows and redemption of ETF shares. This process generally results in fewer capital gains inside of ETFs, making them more tax-efficient.

The ETF share class structure can help lower the overall cost to investors in both the ETF and the mutual fund.

What to Consider in Switching to an ETF Share Class

If many or all of the pending requests for exemptive relief to offer ETF share classes are approved, it could further accelerate the shift in assets from mutual funds to ETFs.

Expenses should be considered. In general, ETF expenses are lower than those for similar mutual funds due to the structure of ETFs. This trend may be further reinforced if the ETF share class draws a significant percentage of the assets from the mutual fund version to the ETF share class. A larger asset base generally means a lower expense ratio.

From a tax standpoint, the ETF share class will likely have the advantage for clients holding the fund in a taxable account.

In the case of active strategies, an active ETF will generally be a lower cost option when compared to an active mutual fund. Active ETFs are still relatively new, so in the case of an ETF share class being approved for an actively managed mutual fund, you will need to assess if the ETF share is a good option.

What Should Advisors Do Now?

While it seems likely that the SEC will approve many — if not all — of the applications to add ETF share classes to existing mutual funds or to allow the conversion of mutual funds to ETFs, there is no timetable for the agency to do so. And nothing is guaranteed. For example, the SEC rejected Vanguard’s application nine years ago to add ETF share classes for some of its active mutual funds.

While waiting for the outcome of the SEC’s reviews, there are several things you can be doing with clients:

• Educate them about ETFs and how they might be a good fit for their portfolios. This might include new ETF shares if approved or moving from some current mutual fund holdings to existing ETFs offered by other asset managers. 
  
• Look at potential opportunities for holdings in a client’s portfolio that might be approved for an ETF share class. In most cases, there would be an opportunity for clients to do a tax-free exchange from the mutual fund to the ETF share class if approved. Assess your client’s holdings and determine if switching from a mutual fund to an ETF share class would make sense. 
  
• Monitor the SEC review and approval process for any affected mutual fund holdings in client portfolios. Keep clients in the loop and share your thoughts as to what you would propose if the ETF share class is approved.