Many mutual funds are converting to exchange-traded funds. Here's what investors need to know (2024)

FAQs

Why are mutual funds converting to ETFs? ›

Once converted to an ETF, the fund can take advantage of the potential tax benefits afforded by the creation and redemption mechanism of ETFs. Also, ETFs feature daily trading, enhanced transparency, and typically have lower fees relative to a mutual fund. With that said, there are some drawbacks and impediments.

How do ETFs work? Exchange-traded funds work like this: The fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors. Shareholders own a portion of an ETF, but they don't own the underlying assets in the fund.

Mutual funds are open-ended funds that are not traded on an exchange. Transactions occur once per day, with orders executed at the net asset value (NAV) at the market close. Investors buy and sell units directly to the fund. In contrast, ETFs trade like stocks on a stock exchange.

Mutual funds and exchange-traded funds (ETFs) are two distinct products – there is no way to transfer funds directly from one to the other. You must first sell your mutual funds and then purchase ETFs.

Any fractional shares of the mutual fund held at the point of conversion will be redeemed and could result in a taxable gain. A conversion may also require approval from shareholders, and if enough shareholders don't want to convert, fund managers may opt to offer a separate ETF that runs the same strategy.

Unlike ETFs, mutual funds can offer more specific strategies as well as blends of strategies. Mutual funds offer the same type of indexed investing options as ETFs but also an array of actively and passively managed options that can be fine-tuned to cater to an investor's needs.

In terms of safety, neither the mutual fund nor the ETF is safer than the other due to its structure. Safety is determined by what the fund itself owns. Stocks are usually riskier than bonds, and corporate bonds come with somewhat more risk than U.S. government bonds.

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.

ETFs offer easy access to a diversified portfolio of assets. They're traded on stock exchanges throughout the trading day, providing you with the flexibility to buy or sell shares at market prices. ETFs typically have lower expense ratios than mutual funds because more of them are passively managed.

What are the pros and cons of exchange funds? ›

Are Exchange Funds a good idea? Yes, exchange funds is a good option for investors with concentrated stock holdings looking to diversify their portfolios while deferring taxes. They come with some disadvantages, such as deferred tax liability, fees, complexity, limited availability, and less control over investments.

While exchange funds provide diversification, they will not protect against broad market declines. Investors must remain in a fund for at least seven years before redeeming shares, and those who leave prematurely may face penalties and only receive their original shares back.

Stocks are traded during regular market hours. Some ETFs can be purchased commission-free and are cheaper than mutual funds because they do not charge marketing fees. Some mutual funds do not charge load fees, but most are more expensive than ETFs because they charge administrative and marketing fees.

ETFs often generate fewer capital gains for investors than mutual funds. This is partly because so many of them are passively managed and don't change their holdings that often. However, ETFs also have a structural ability, called the in-kind creation/redemption mechanism, to minimize the capital gains they distribute.

If you sell shares in most ETFs within a year, any profits are taxed as a short-term capital gain. ETFs held for longer are considered long-term gains and given a lower rate. If you sell an ETF and buy the same (or a substantially similar) ETF after less than 30 days, you may be subject to the wash sale rule.

Since early 2021, there have been more than 70 mutual fund to ETF conversions, including nearly three dozen in 2023, according to Morningstar Direct, and experts say more conversions are coming.

Whether ETFs are a good choice for you depends on what you want to get from your investment. If you're looking for an affordable investment likely to generate moderate returns, sacrificing the potential for higher gains in exchange for lower risk, then ETFs can be an excellent option.

In addition to phone support from knowledgeable personnel, mutual funds may offer check-writing options and other shareholder services that ETFs don't provide. Dividend reinvestment plans (DRIPs) take the stress of decision-making by automatically converting dividend distributions into investment growth.

In 2024, its data shows total net outflows of about $38 billion, with April seeing the largest asset loss for mutual funds at $41.9 billion. The outflows were countered by one month of inflows, with February clocking a positive $15.7 billion and showing that mutual funds certainly still have their place in the market.