Investors pulled $1 trillion from mutual funds last year while adding $28 billion to exchange-traded funds (ETFs), according to Bloomberg Intelligence. So, Bloomberg’s prediction that about $1 trillion worth of mutual fund assets could be converted into ETFs over the next decade shouldn’t come as a surprise to anyone.
But, as with any new trend, growing pains are starting to emerge. Asset managers are discovering that a mutual fund conversion is far from a guarantee for success in the ETF market. And the SEC is beginning to take a closer look at “governance and disclosure” concerns, according to its recent 2023 Examination Priorities Report.
In this article, we’ll examine some of the SEC’s concerns and what it might mean for the mutual fund to ETF conversion trend.
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How to Handle 12b-1 Fees
Many mutual funds charge 12b-1 fees to cover the cost of marketing and selling shares, as well as the cost of providing shareholder services. For example, these fees typically include the cost of printing and shipping sales literature and prospectuses to investors. Or, it might cover the fees paid to individuals to respond to investor inquiries.
But what happens to 12b-1 fees following a mutual fund to ETF conversion?
Since ETFs rarely charge 12b-1 fees, it’s unclear whether a mutual fund could use its accrued fees to promote its converted ETFs, according to ETF Hub. Eliminating 12b-1 fees after deciding to make a conversion—rather than at the moment of conversion—could save shareholders money. And, as a result, it might be the better governance decision.
Broader Conversion Concerns
The SEC’s 2023 Examination Priorities Report outlines several focus areas for mutual funds and other registered funds.
In particular, the report states the Division will also focus on funds with specific characteristics, such as:
- Turnkey funds to review their operations and assess effectiveness of their compliance programs
- Mutual funds that converted to ETFs to assess governance and disclosures associated with the conversion to an ETF
- Non-transparent ETFs to assess compliance with the conditions and other material terms of their exemptive relief;
- Loan-focused funds such as leveraged loan funds and funds focused on collateralized loan obligations for liquidity concerns and to review whether the funds have been significantly impacted by, and have adapted to, elevated interest rates
- Medium and small fund complexes that have experienced excessive staff attrition to focus on whether such attrition has affected the funds’ controls and operations
The Division will also monitor the proliferation of volatility-linked and single-stock ETFs, and may review such funds’ disclosures, marketing, conflicts, and compliance with portfolio management disclosures, among other things.
Beyond 12b-1 fees, the agency may be seeking a better understanding of the governance and disclosure of mutual fund conversions. For example, they’re asking for funds to describe these processes and the rationale behind them. These are likely more ‘exploratory’ measures to assess the need for more precise guidance and ensure investors are safe.
At the same time, it’s worth noting that the SEC’s priorities aren’t exclusively focused on mutual fund conversions. The agency is also looking to reign in volatility-linked and single-stock ETFs while assessing loan-focused funds and other leveraged vehicles to ensure they don’t introduce systemic risks to the financial system.
The Bottom Line
Mutual fund to ETF conversions will continue to be a megatrend in asset management as investors transition to cheaper, more flexible investment vehicles. As a result of the rapid growth, the SEC made it clear that it would seek to understand governance and disclosure, and 12b-1 fees could come under the microscope.
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