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.
Important Disclosures
Exchange Traded Concepts is an SEC Registered Investment Adviser. The Firm's Form ADV is publicly available and can be found here: https://www.adviserinfo.sec.gov/Firm/151197. ETC may be subject to various conflicts of interest in the provision of its services. Potential conflicts of interest shall be identified in the Firm's Form ADV. The Exchange Traded Funds are referred to as "Funds" for purposes of this document. ETC transacts business in the United States and other jurisdictions where it is properly registered or excluded or exempted from registration requirements. This document does not constitute an offer of services in jurisdictions where ETC does not have the necessary licenses.
No representation is made that any Fund's investment process, objectives, goals or risk management techniques will or are likely to be achieved or be successful or that any Fund or any underlying investment will make any profit or will not sustain losses. The risks of investing in a Fund will not be negated by ETC's Fund services, and no assurance is given that a Fund will not be exposed to risks of significant trading losses.
The information provided herein does not constitute tax, legal or accounting advice. ETC does not provide legal, financial, accounting or tax advice. Clients and prospective Clients, as well as investors and prospective investors in a Fund ("Investors") are advised to seek the counsel of their own legal, financial and tax advisors for all matters relating to the services and structures contemplated herein. Each Investor (either alone or with its professional advisors) is solely responsible for its own due diligence, risk assessment and tolerance, investment objectives, any decision to invest in a Fund, and for monitoring its investment for purposes of determining whether it wishes to remain invested in such product and whether such product continues to be appropriate for its circumstances and requirements.
The information provided herein: (a) is provided as of the date indicated, (b) is in summary only and is not complete, and (c) is subject to change at any time without notice. Certain information provided by ETC is based on third-party sources and, although generally believed to be reliable, has not been independently verified. ETC is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness, or timeliness of such information, and ETC assumes no obligation to update or otherwise revise such information. In no event will ETC be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees or losses (including, without limitation, lost income or lost profits and opportunity costs) in connection with the use of the information contained herein, even if advised of the possibility of such damages. ETC and its respective employees and its affiliates hereby exclude, to the extent permitted by applicable law, all liability in connection with the use of the information herein.
Interests in Funds will not be insured by the FDIC, the SIPC or any other organization, will not be deposits of any bank, and are not guaranteed by any bank.