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The prospect of converting existing mutual funds into actively-managed ETFs was first brought up for discussion by Bill Thomas, CEO of Grail Advisors, who in an interview with ActiveETFs | InFocus provided more insight on the value proposition behind the conversion of a mutual fund into an ETF structure. Grail Advisors was reportedly in talks with a couple of fund companies to convert their existing active mutual fund into an actively-managed ETF. However, not much was heard on the topic since then until the filing by Huntington Asset Advisors on June 17th to launch two new Active ETFs.

As InvestmentNews reports, one of the funds that Huntington Asset Advisors plans to launch – the Global Rotating Strategy Fund – follows an existing strategy already offered through a mutual fund called the Huntington Rotating Markets Fund (HRIAX). Randy Bateman, the president and CIO of Huntington, indicated to InvestmentNews that once that Active ETF gains some traction, HRIAX will be rolled into ETF structure. This is the first case in the US where an issuer has explicitly indicated an interest in rolling an existing active mutual fund into an Active ETF structure. In Canada, this has already been tried and tested with a fund run by Horizons AlphaPro. AlphaPro chose to convert its existing Horizons AlphaPro Gartman Fund, managed by the well-known Dennis Gartman, into an actively-managed ETF in Nov, 2009.

There’s a couple of reasons why converting an active mutual fund into an actively-managed ETF could be appealing for issuers.

1. Instant Track Record

One of the big issues standing in the way of Active ETFs gaining significant traction is that being so new, most of these funds lack an established track record. And as with any actively-managed product, having a strong and lengthy track record is paramount to gaining investor trust and assets. As such, most Active ETFs are biding their time until they have enough years of performance to deserve a Morningstar rating and achieve some recognition.

In the case of conversions though, the situation is quite different. For example, the existing mutual fund run by Huntington, the Huntington Rotating Markets Fund, already has a 9-year track record during which time the fund has returned 15.44% compared to 5.58% by the S&P500 during the same time period. So as long as the actively-managed ETF that this fund is folded into has the same investment mandate, investors will have a much longer track record that they can look to in order to evaluate and gain confidence in the manager. Such an advantage can be crucial if a comparable strategy was to hit the market from a competitor but one where the manager behind the Active ETF had to build his/her track record from scratch.

2. Unbundling And Reducing Expenses

The second big reason for conversion is that the ETF structure would be more beneficial to existing investors from an expense point of view. Firstly, an actively-managed ETF “unbundles” the MER that investors have to pay when in a mutual fund. When invested in a mutual fund, investors see a headline expense that includes the product cost, the advisor’s trailer fees, operating fees etc. With an Active ETF, the headline expense that investors see excludes any trailer fees because ETFs don’t usually pay trailers to advisors. As such, the advisor’s compensation is separated from costs related to the actual investment product. Secondly, the actual operating expenses of an Active ETF are lower than that for a comparable mutual fund, again lowering the headline expense. So, for the issuer, the conversion is a revenue-neutral process because their investment management fee likely remains the same, while the shareholders benefit from a lower operating expense and also a lower headline cost.

Downsides

There are still some issues though that investors would need to contend with if their mutual fund gets converted into an ETF. One of the main ones is that investors would have start paying transaction fees when going in or out of the ETF, an expense they wouldn’t have had to bear previously. However, with the annual operating expenses being lower, and investors usually putting their money with an active manager for the long haul, this is likely not as big of an issue.

Disclosure: No positions in above-mentioned names.

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Source: Rolling Mutual Funds Into Active ETFs