Presto, Change-O! That Fund is Now an ETF

Welcome to Deconstructed, a weekly newsletter from Financial Advisor IQ that breaks down news and perspectives on portfolio construction.

So far this month, several big fund companies have unveiled plans to shake up the structure of their mutual fund menus. At least two of these changes are clear long bets on exchange-traded funds as the product of choice for advisors and their clients.

Pimco is among the latest shops to jump on the fund-to-ETF conversion bandwagon.

The Newport Beach-based manager said it plans to convert its $141 million Mortgage-Backed Securities fund to an ETF, in late September, pending board approval. The strategy would keep its management team and basic investment objectives, but shed its 12b-1 fee and provide shareholders "other potential benefits," the firm said in a filing.

The March 1 filing didn't indicate what the ETF will cost, though the document notes that Pimco plans to close most share classes to new money as of June 3.

Institutional shares of the existing mutual fund charge a 50 basis point management fee and 112 bp in total expenses.

Pimco's website shows at least two other mortgage-linked open-end fixed-income funds on its menu but no ETFs in the category.

Swapping the fund structure plugs that hole, a spokesperson told Financial Advisor IQ sister-title, Ignites.

Going with the Flow(s) Pimco's Mortgage-Backed Security mutual fund is the firm's first ETF conversion, but is part of an ongoing industry trend. To date, 73 mutual funds have morphed into ETFs, and a BNY Mellon report from last month shows that 44% of fund managers expect more such switches.

Fidelity, JPMorgan and Dimensional Fund Advisors are among the shops that have waved the ETF wand over the greatest number of existing products.

That may be because industry data shows that ETFs across the board—be them active or passive—seem to be the vehicle of choice for advisors and clients working in taxable accounts.

Here's a look at how ETFs have attracted assets, while mutual funds, overall, bled over the past five years.

Last year, while less than one-third of all active funds and 43% of passive funds clocked new sales, 67% and 50% of ETFs managed to do so.

In part, it may be the generally skinnier fees ETFs levy compared to mutual funds – they skip operational considerations like transfer agency and (generally) have no built-in sales charges. They are also more tax efficient, which can be a boon to investors.

More than One Way to Skin a Fund Converting smaller products to ETFs can be a boon to managers, too. For one, fund providers can port over the product track record that may have struggled to get noticed or win new assets. Repackaging a strategy in an ETF wrapper can, with a bit of a marketing push, kick-start new sales. That's particularly true if the fund company thinks a fund is a victim of broader trends (see graphics above) or has internal competition.

But conversion isn't for everyone. Funds with traction in the 401(k) market, for example, can be tricky. There are some operational concerns as well.Another path firms may pursue is to create a share class of the original fund. Vanguard patented that process more than two decades ago. That protection helped the Malvern, Penn.-based firm's line swell to $2.5 trillion, making it second in size only to BlackRock's iShares among U.S. ETF providers.

The Vanguard patent expired last May, clearing the path for rivals. Check back next week for more on the funds that may be seeking that option.

Adrian D. Garcia contributed the graphics to this newsletter.

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