From time to time the markets will do something that seems both significant and inconsequential at the same time. Significant in that it is potentially very important, and to some investors it will matter quite a lot. Inconsequential in that, to most investors, the event likely won’t change their financial position or outcomes. This duality certainly applies to the growing trend of mutual funds converting to exchange-traded funds (ETFs), which you may want to understand in the context of your retirement portfolio.
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Growing Trend: Mutual Funds Converting to ETFs
As Fidelity reported recently, there’s a growing shift in the mutual fund industry. Since March 2021, more than 50 mutual funds comprising $60 billion-plus in value have converted to ETFs, according to the report. This trend is gaining steam, with Fidelity even mentioning that its own team has converted six mutual funds into ETFs.
By converting to an ETF, a mutual fund’s financial position can remain largely the same. Traditionally, mutual funds are characterized as more active portfolios designed to try and beat market returns. On the flip side, ETFs are characterized as more passive portfolios designed to index a given market or metric. This is by practice, however, rather than law. Mutual funds and ETFs are both portfolios that usually hold the same categories of underlying assets. That is to say, both can invest in stocks, bonds, money-market funds and other mainstream assets. So a converted fund can, if it chooses, maintain its original financial position.
However, by converting to an ETF, a fund gains significant liquidity advantages. ETFs are easier to buy and sell, particularly for retail investors. They also generally have lower overhead costs and can be marketed directly to individual investors rather than requiring third-party brokers. All of this appears to be making the ETF an attractive structure for investment companies.
This movement represents a tiny share of the fund market overall. While estimates range, the U.S. mutual fund market is generally valued at around $30 trillion. Most estimates suggest there are over 7,000 active funds traded in the U.S., so 50 funds represent a tiny share of the market overall.
However, it’s the momentum that has attracted this level of attention.
ETFs have exploded in popularity in recent years. While more than 400 new ETFs came into the market each year in 2022 and 2021, the number of mutual funds has modestly declined in that same period. As a result, there is good reason to think that the rate of mutual fund conversions will continue, if not grow. Indeed, Fidelity expects to see much more of this just in the coming months.
How the Mutual Fund Conversions Affect You
For institutional and professional investors this is a big deal. The technical and structural differences here are significant, from strategic transparency to market competitiveness. But for individual investors like you, what should you do?
For many investors, this shift will largely be a non-factor.
Most Americans hold investments mainly through a retirement account such as 401(k) plans, IRAs or a pension fund. In these cases, rules may prevent a mutual fund conversion. As Fidelity writes, “mutual funds that are included in 401(k) plans are unlikely to be a candidate for conversion, as most of these retirement plans offer mutual funds or collective investment trusts only.”
If a mutual fund currently in your portfolio does convert to an ETF, these retirement funds would simply cycle it out in favor of a mutual fund with comparable benchmarks and performance. From the perspective of a 401(k) investor, it’s unlikely that this would be a noticeable event beyond, potentially, some one-time taxes against the portfolio.
Lower Taxes and Costs
This is an area that investors might notice. ETFs tend to be somewhat cheaper to own than mutual funds.
First, ETFs generally have lower overall fees than mutual funds. On average, an ETF will charge less than 0.5% in annual expense ratios, which are management fees.
Conversely, mutual funds typically charge between 0.5% and 1.5% for those same costs. Most mutual funds also charge what is known as a 12b-1 fee. This is an annual fee that can run as high as 1.25%+ depending on the fund. ETFs, however, do not charge any 12b-1 fees.
Finally, ETFs tend to have lower taxes than mutual funds. This is because a typical ETF will have fewer tax events than a mutual fund, meaning that it generally buys and sells assets less often. This leads to some efficiency, although it’s important not to overstate the gains. For instance, The Wall Street Journal found that ETFs tend to have an advantage of only about 0.2%.
ETFs offer a little more flexibility and slightly lower fees than their mutual fund counterparts. If a mutual fund that you already own converts, it might boost your overall returns modestly by lowering your taxes and fees, by only by a small margin. Otherwise, this is not likely to affect your portfolio significantly. So, in general, there’s no need to change your allocations or sell an asset that’s otherwise working for you purely because it made a conversion.
Retirement Planning Tips
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