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Trendspotter: Why Many New ETFs Look So Familiar to Mutual Fund Investors

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The Trend

A growing number of established mutual fund companies, including T. Rowe Price and Dimensional Fund Advisors, are launching ETFs by either converting existing mutual funds or maintaining those funds and launching ETF look-alikes, adding to the growing number of ETF assets.

Citigroup analysts project that ETF assets will eventually outnumber mutual fund assets, which currently total $21 trillion — about four times the level of ETF assets.

The Drivers

  • Advisor demand for ETFs, especially for taxable accounts (ETFs are more tax-efficient than mutual funds)
  • The SEC ETF Rule 6c-11 under the 1940 Act, which allows all passive and active transparent ETFs to make use of custom baskets. The rule also allows for faster ETF launches because asset managers no longer have to file for exemptive relief every time they launch a new ETF. The rule took effect in late December 2019, but asset managers had a one-year window to achieve full compliance.
  • The emergence of semi-transparent ETFs, which began in spring 2020 about a year after the SEC approved the first of several nontransparent ETF structures
  • Lower fees, which can attract more investors and help asset managers grow assets and stem outflows

The Buzz

Tim Coyne, global head of ETFs, T. Rowe Price:

(Note: T. Rowe introduced its first ever ETFs in August 2020 — four active semi-transparent equity ETFs that are similar to existing equity mutual funds, bringing in around $290 million in assets  — and a fifth this month.)

“ETFs allow clients to reach our strategies through a new pathway. … The benefits to clients are lower operating costs and enhanced tax efficacy through the creation and redemption mechanism of ETFs which appeals to taxable clients, retail and institutions.

“We’re pleased with the level of client engagement [with our ETFs] … and have plans to continue to develop our ETF product suite across equities and fixed income. We’re in the process of developing fixed income capabilities ETFs for our ETF plan later this year…. Many advisors have developed a preference for ETFs as an investment holding. ETFs give T. Rowe Price the opportunity to expand our reach particularly across the advisor universe and broadly across [other] intermediaries. Also, ETFs on most platforms are commission accessible through brokerage accounts.”

On why T. Rowe Price didn’t go the mutual fund conversion route when introducing ETFs, Coyne said: “If you look at the asset base of T. Rowe Price, a significant amount is in retirement accounts. From an operational standpoint [conversions] would be challenging.”

On why the firm chose to introduce semi-transparent active ETFs: “Semi-transparency protects our intellectual property, and through proxy baskets and intraday metrics you can see performance of proxies relative to actual fund holdings.”

(All of the firm’s active ETFs use a proprietary proxy basket that provides market makers the information they need to quote prices confidently while protecting the “secret sauce” of portfolio managers’ operations to avoid front-running).

Marlena Lee, head of investment solutions, DFA:

Note: Dimensional Fund Advisors, which sells its mutual funds exclusively through financial advisors, launched its first-ever ETFs in November and December, and this week the firm launched four of six planned active equity ETFs that were tax-free conversions of tax-managed mutual funds. It expects to launch the other two active ETFs this September. All of its ETFs are fully transparent.

“We want to give our clients the choice in how they invest in the U.S. We launched our ETFs because of client demand … The motivation for the launch was to give clients the choice. The ETF rule allows us to bring our flexible [investment] system approach to the ETF form. It clarified the use of non-standard or non-pro rata shares.”

Lee explained, for example, that if an ETF holds 2,000 stocks and not all are so liquid to trade daily, the authorized participant who helps creates and redeem shares in an ETF can now use a basket of stocks for creation that can include hundreds of other names that are similar to stocks in the ETF but are more liquid, which helps keep spreads in line.

DFA’s first three ETFs attracted about $1.5 billion in the first five months. Its ETFs formed from mutual fund conversions also have lower fees than their predecessor funds — “one of the benefits” of the conversions, according to Lee.

“We have fixed mutual funds but no bond ETFs,” he said. “Eventually that’s something we’re looking at and evaluating.”

Ben Johnson, director of global ETF research, Morningstar:

“The ETF trend which began in earnest … with the Pimco Total Return ETF that started as TRXT then BOND is well underway and has accelerated more recently in large part [due] to (1) the ETF rule which affords managers greater flexibility than previously to use custom baskets to deliver tax-efficient active strategies and (2) approval of nontransparent ETFs which allows discretionary stock portfolio managers to get more comfortable in delivery strategies in ETFs than if they had to be fully transparent. The custom basket … was the impetus for many [asset managers] to get off the sidelines.

“Directionally you’re going to see in years to come … that nontransparent ETF format and fully transparent ETFs will be indistinguishable from each other. The only differentiating feature will be whether they disclose portfolios every day or use a custom basket.

“Not on the bill for ETFs are marketing and distribution costs of mutual funds. And recordkeeping costs tend to be lower as well. … But investors need to be cognizant of premiums and discounts [to net asset value]. Investors need to respect what an ETF stands for. There’s not a guaranteed NAV on the close every day.”

Johnson expects to see more first-time ETF launches by major asset managers. “The most meaningful event will be Capital Group’s entry into the ETF arena,” he says.

In January, Capital Group, the parent company of American Funds, announced plans to launch equity and fixed income ETF strategies in early 2022, and in April it announced that it has filed for an application with the SEC for for exemptive relief based on Fidelity’s active equity ETF methodology for nontransparent ETFs.


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