Many mutual fund strategies are launching as ETFs: What it means for investors

Adam

Summary:

More mutual fund strategies are becoming ETFs, offering lower fees, better tax efficiency, and clearer holdings for investors.

Asset managers are debuting more of their mutual fund strategies as exchange-traded funds, a move that seeks to capitalize on ETF popularity in recent years and also benefits many retail investors, according to market experts.

Money managers have taken a few approaches.

Many have converted specific mutual funds to ETFs. Fifty-six mutual funds were converted to ETFs in 2024, a number that has increased steadily from 15 in 2021, according to Morningstar data. Another 40 have done so this year.

Others have opened an ETF “clone” of a specific mutual fund, which allows investors to choose from the mutual fund or ETF version of an investment strategy.

Additionally, more than 80 asset managers have sought permission from the Securities and Exchange Commission to launch an ETF share class of their existing mutual fund portfolios, said Bryan Armour, director of ETF and passive strategies research for North America at Morningstar.

This is a slightly different strategy from the others. Mutual funds are generally available in a variety of share classes; in this case, the ETF would be another share class and share the same portfolio as mutual fund investors.

“This is one of the biggest trends in the fund market right now,” Armour said. “Over the next two years, we’d expect a large number of ETF share classes to be used heavily.”

The SEC green-lit the first application, for Dimensional Fund Advisors, on Sept. 29.

“We’re sort of waiting for the next shoe to drop, and my guess is it would have happened were it not for the government shutdown,” Armour said, in reference to the SEC approving more applications.

ETF popularity

ETFs and mutual funds are broadly similar: They are relatively liquid baskets of stocks, bonds and other assets overseen by professional money managers, and can help investors diversify their portfolios.

Investors have shown a strong preference for ETFs in recent years.

Investors poured about $1.1 trillion into U.S. ETFs in 2024, a record high, according to Morningstar. Meanwhile, investors withdrew $388 billion from U.S. mutual funds.

ETF assets still account for just one-third or so of the total U.S. fund market, but are gaining ground: They had a 14% market share relative to mutual funds at the end of 2014 and a 5% share in 2004, for example, according to Morningstar.

That popularity is mainly due to key differences that many financial advisors say make ETFs a generally better financial choice for retail investors.

Exchange-traded funds are generally more tax-efficient, thereby saving investors from surprise annual tax bills on capital gains distributions, and tend to have lower annual fees than mutual funds, according to certified financial planner Blake Pinyan, a senior financial planner and tax manager at Anchor Bay Capital in Carlsbad, California.

ETF holdings are also more transparent for investors, Armour said. Asset managers must disclose their ETF holdings every day, while mutual funds typically do so on a monthly or quarterly basis.

“ETFs have become so much more prominent in the market,” Armour said. “At a high level, asset managers are trying to capitalize on demand,” he added.

How to decide: ETF or mutual fund?

Investors who have taxable brokerage accounts should generally aim to hold ETFs in such accounts, due to their tax efficiency, Pinyan said.

“Avoid mutual funds in taxable accounts,” said Pinyan, who is a member of CNBC’s Financial Advisor Council. “Having a mutual fund in a taxable brokerage account could result in the investor paying a lot more in tax liability. They’re very tax-inefficient.”

Exchange-traded funds aren’t necessarily better in all circumstances, though, experts said.

For example, an ETF’s tax benefits are moot in tax-preferred accounts like IRAs and in 401(k) plans, experts said.

Additionally, investors should pay attention to whether an ETF “clone” of an actively managed mutual-fund strategy is an “identical twin” or a “cousin,” wrote Gregg Wolper, a senior manager research analyst of equity strategies for Morningstar Research Services.

In other words, an ETF portfolio that’s a “cousin” may be similar but not identical to the same manager’s mutual fund, he wrote, and therefore may not be well-suited to all investors depending on preferences.

If the SEC approves more applications for asset managers to launch their mutual funds in an ETF share, it could come with a potential drawback for some ETF investors: shared tax exposure with mutual-fund shareholders, according to a Morningstar analysis published in October.

That could dilute some of the relative tax benefits for ETF investors, though such an occurrence would likely be rare, it said.

“Certain situations, often prompted by the actions of investors in the mutual fund, can leave investors in the ETF share class on the hook for capital gains distributions,” it said.

Source: cnbc

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