Things to consider before converting your SMA to an ETF

The unique creation-redemption mechanism and intraday trading that is central to ETFs can provide significant benefits such as ease of use, liquidity, and a higher level of tax efficiency.
 

As outlined in prior articles, the unique creation-redemption mechanism and intraday trading that is central to ETFs can provide significant benefits for advisors and their clients. These benefits include ease of use, liquidity, and a higher level of tax efficiency.

However, there are several logistical factors that need to be considered before making the decision. Making sure a plan is in place to tackle these issues can help to ensure the process goes smoothly and allows for success of the ETF after the conversion is completed.
 

Gaining Client Permission

Before converting to an ETF, current investors within the SMA will need to provide permission for the conversion to happen. Rather than needing every investor to take action to affirm the conversion, it is possible to receive the necessary approval through sending a negative consent letter.

This letter will inform the recipient of an impending action (the conversion) and give them a specified time frame to respond if they object to the conversion. This way, no specific action is required on the part of the investor which simplifies the process, paving the way for an easier conversion process.
 

Recordkeeping Requirements

Before converting an SMA into an ETF, accurate recordkeeping of the SMA is necessary. This means logging the cost basis of all positions in every client account. This process is necessary because even though all assets will be contributed in-kind to the authorized participant while being pooled within the ETF, current clients will need to have ETF shares issued at a cost basis that reflects their prior investment.

In other words, while the conversion itself is not a taxable event, maintaining accurate records prior to conversion is essential to ensure the client receives the ETF at the appropriate cost basis, and is able to accurately realize capital gains or losses when they sell ETF shares going forward.
 

Bringing Your Own Assets

Finally, the advisor should consider whether the strategy has a sufficient level of assets before beginning the conversion process. While converting into an ETF does provide the benefit of wider access to the strategy, it is highly unlikely to draw in millions in new money overnight.

One thing to consider is that there is often a minimum asset value that is required for strategies to be included on various platforms. While each platform will have their own specific guidelines, $25-$50 million is often a good benchmark to use when considering what asset minimum might be necessary for approval.

However, it could take an even higher asset value for the ETF to “break even” on costs. While the exact amount will vary depending on the expense ratio of the ETF itself, it is estimated that at least $40-45 million in assets under management is necessary to reach this breakeven point.
 

Converting a strategy that already has the asset level necessary for inclusion on various platforms and be self-sustaining from a cost perspective is a best practice, reducing the pressure to gather assets quickly in a competitive marketplace.

If you are interested in learning more about these issues, contact us to discuss our expertise in helping seamlessly transition SMA and mutual fund strategies into an ETF.