Mutual Fund to ETF Conversions Come Under the SEC's Radar

Many mutual funds charge 12b-1 fees to cover the cost of marketing and selling shares, as well as the cost of providing shareholder services. For example, these fees typically include the cost of printing and shipping sales literature and prospectuses to investors. Or, it might cover the fees paid to individuals to respond to investor inquiries.

But what happens to 12b-1 fees following a mutual fund to ETF conversion?

Since ETFs rarely charge 12b-1 fees, it’s unclear whether a mutual fund could use its accrued fees to promote its converted ETFs, according to ETF Hub. Eliminating 12b-1 fees after deciding to make a conversion—rather than at the moment of conversion—could save shareholders money. And, as a result, it might be the better governance decision.

The SEC’s 2023 Examination Priorities Report outlines several focus areas for mutual funds and other registered funds.

In particular, the report states the Division will also focus on funds with specific characteristics, such as:
 

• Turnkey funds to review their operations and assess effectiveness of their compliance programs
• Mutual funds that converted to ETFs to assess governance and disclosures associated with the conversion to an ETF
• Non-transparent ETFs to assess compliance with the conditions and other material terms of their exemptive relief;
• Loan-focused funds such as leveraged loan funds and funds focused on collateralized loan obligations for liquidity concerns and to review whether the funds have been significantly impacted by, and have adapted to, elevated interest rates
• Medium and small fund complexes that have experienced excessive staff attrition to focus on whether such attrition has affected the funds’ controls and operations

The Division will also monitor the proliferation of volatility-linked and single-stock ETFs, and may review such funds’ disclosures, marketing, conflicts, and compliance with portfolio management disclosures, among other things.

Beyond 12b-1 fees, the agency may be seeking a better understanding of the governance and disclosure of mutual fund conversions. For example, they’re asking for funds to describe these processes and the rationale behind them. These are likely more ‘exploratory’ measures to assess the need for more precise guidance and ensure investors are safe.

At the same time, it’s worth noting that the SEC’s priorities aren’t exclusively focused on mutual fund conversions. The agency is also looking to reign in volatility-linked and single-stock ETFs while assessing loan-focused funds and other leveraged vehicles to ensure they don’t introduce systemic risks to the financial system.

Mutual fund to ETF conversions will continue to be a megatrend in asset management as investors transition to cheaper, more flexible investment vehicles. As a result of the rapid growth, the SEC made it clear that it would seek to understand governance and disclosure, and 12b-1 fees could come under the microscope.

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