Huntington Asset Advisors could become the first company to convert some of its mutual funds into exchange-traded funds ETFs. In late June, the company filed an exemptive relief order with the SEC to convert its Rotating Markets mutual fund into an actively managed exchange-traded fund.

Recently, professionals in the ETF world have been discussing the merits of converting a mutual fund into an actively managed ETF. A number of mutual fund companies besides Huntington Asset Advisors are believed to be discussing this option.

Why Convert?

From the perspective of the mutual fund managers, converting a mutual fund to an exchange-traded fund has some appeal. If the SEC grants its approval, the fund’s performance history would stay with it after its transformation from a mutual fund to an ETF is complete. In addition, the new ETF will have the same established management reputation and investment and trading style as the original mutual fund.

What are the benefits to the investor of a mutual fund that is attempting to convert its shares? The main pluses are greater transparency and potentially lower fees. At this time, actively managed ETFs are required to publish their holdings on a daily basis. Mutual fund companies are required to do this only quarterly.

In general, exchange-traded funds have lower fees than their mutual fund counterparts due to lower operating expenses and smaller fees associated with running the fund (i.e., purchase and redemption fees). Broker commissions are typically lower for ETFs as well.

How It Works

In describing the process, Huntington Fund’s president and chief investment officer, Randy Bateman, said a clone ETF would be created and funded using the same manager and trustees as the mutual fund. Then, presuming the SEC grants its approval, the mutual fund would be rolled into the new ETF. Existing mutual fund shareholders would receive ETF shares equivalent to the dollar value of their mutual fund holdings.

The new ETF will have its own ticker. At conversion, shares of the mutual fund will be extinct.

If your mutual fund is considering converting to an actively managed ETF, you will be notified.

Costs and Taxes

Though the process has yet to be approved by the SEC, the intent is to affect the conversion without any costs to shareholders or tax liabilities.

Because ETFs are traded on an exchange, fund managers do not have to buy and sell securities to accommodate shareholder purchases and redemptions. This can result in lower annual taxable distributions by the ETF.

Specifically, any realized capital gains earned by a mutual fund must be distributed to shareholders as a taxable gain. These gains are generated by managers selling securities within the fund. On the other hand, ETF investors are generally only taxed on capital gains when they sell their own shares.

If the ETF distributes any dividends from the securities it holds, then the investor is taxed at the prevailing dividend rate.

The Pros for Investors

Longer Track Record

An actively managed ETF can offer a long performance record that is useful for evaluation as well as diversification and risk analysis.

Transparency

Currently, actively managed ETFs must disclose their holdings daily, while mutual funds are only required to do so quarterly.

Lower Overall Costs

Actively managed ETFs have lower overall expense ratios than similar mutual funds and are designed to be more tax-efficient.

The Cons for Investors

Performance

Most actively managed funds fail to beat their benchmarks. This is unlikely to change with the conversion of mutual funds into ETFs. Investors will still need to consider performance and expense ratios before making an investment decision.

Unknown Territory

Converting a mutual fund into an ETF is a new event, and potential problems are currently unknown. For example, liquidity may be an issue if daily trading volume is not high enough to support large redemptions.