The question we keep getting, in various forms, is the following:

  1. Can you do a tax-free conversion of a mutual fund into an ETF?
  2. Can you do a tax-free conversion of SMAs (separately managed accounts) into an ETF?
  3. Can you do a tax-free conversion of a hedge fund into an ETF?

Long story short, yes, yes, and yes…but it’s complicated!(1)

Note: this post was co-written with Sean Hegarty, CPA

Situations where an ETF cannot solve your problems

First, a few things you cannot do (and yes, we have been asked these questions multiple times):

  • Can I run my family office as an ETF?
    • Answer: Maybe. You cannot use an ETF as your own personal tax deferral device. You need to have a business purpose for operating an ETF. Reach out to discuss further.
  • Can I seed an ETF with my low-basis IPO stock shares [or fill in the blank monster winning stock]?
    • Answer: No. You cannot dump a single stock position into an ETF and then diversify tax-free. There are strict diversification tests required to maintain an ETF’s status as a registered investment company (see below).

When can a tax-free ETF conversion potentially solve my problems?

Here is the bottom line: You can convert an existing diversified portfolio of stocks into an ETF. But it involves a decent amount of brain damage. Of course, the potential benefits for you and/or your clients are the ability to leverage the tax efficiency of the ETF and the ability to make your advice fees tax-deductible. Advisory fees are generally not deductible. But management fees inside a registered fund can be netted against income, effectively making them tax-deductible.

Again, the exact details on ETF conversions are complicated and involve the specific fact patterns around your situation, but here are some high-level requirements to convert your current investment vehicle into an ETF, tax-free. Please note that when you convert your current asset base into an ETF you do not ELIMINATE taxes, you simply carry over your basis from your underlying investments, and your old basis is now the basis in your ETF shares.

Questions to ask if you are thinking of converting a mutual fund (or SMA or hedge fund) into an ETF

When contemplating the question of whether or not to convert a mutual fund into an ETF (or an SMA or hedge fund, for that matter), it is useful to ask yourself the following questions:

  • Is your intent to continue your business in the ETF structure or is your transaction strictly for tax purposes? Intent matters.
  • Ideally, no individual person should own a large percentage of the outstanding shares of the ETF. This will avoid making a passive ETF investor a “control person.” If the large owner is affiliated with the fund (i.e., own the ETF company) this may be less of a concern.
  • ETF structures are for investing not day-trading. Transaction-heavy investment strategies don’t work well in an ETF.
  • The underlying assets need to be US liquid exchange-traded stocks (or ADRs). International stocks are doable, but it adds complexity.
  • No single stock position can be larger than 25% of the net asset value. Realistically, you need to be under 20%.
  • The sum of 5%+ positions in your portfolio must be less than 50% of the net asset value. Ideally, this is less than 40%.
  • Ideally, the portfolio contains at least 25 positions.
  • For SMA situations, it is easier if all the contributing portfolios are roughly similar, but it is not a hard and fast requirement.
  • See section 851 for more details.

A practical example of an SMA to ETF Conversion

Acme RIA has 10 separately managed accounts with a low basis in Berkshire Hathaway stock. BRKA represents 50% of their portfolios and the other 50% is an equal weight portfolio of 50 random stocks. Can you convert these portfolios into an ETF? Kinda.

BRKA is over 25% of the portfolio value (i.e., 50% in this example) and would break the diversification requirement described above. In order to facilitate this transaction, each of the 10 SMAs would only be able to contribute 24.99% as BRKA, and the remaining 75% would need to be represented by the equal-weight portfolio of 50 random stocks. The remaining block of BRKA would need to be held in the SMA and could not be part of the conversion transaction. The ETF, after conversion, would be 24.99% BRKA, and 75.01% in the 50 remaining stocks. Once the ETF is operational, Acme RIA, the portfolio manager of the ETF, could actively manage the portfolio to achieve its stated prospectus goals.(2)

Here are some additional weeds on the situation above:

  • All of this falls under tax-free conversions via 351: 26 U.S. Code § 351 – Transfer to corporation controlled by transferor
  • Each transferor must send a “diversified” portfolio of securities based on 26 U.S. Code § 851 – Definition of regulated investment company https://www.law.cornell.edu/uscode/text/26/851
  • 5% names must make us less than 50% of the transferred portfolio (Other RICs are excluded ~ read as GOOD ~ for this test). So you could transfer a bunch of low-basis ETFs in the conversion.
  • No name greater than 25%.
  • No controlled securities totaling 25% in the same industry.
  • No QPTPs totaling 25% (make life easy and hang on to your partnerships!)

Here are the mechanics, at a high level, on a tax-free conversion of SMA accounts into an ETF structure:

  • Get a list of all of your potential clients who could benefit – make sure AFTER the conversion there is no double dipping of fees.
  • Work with your custodians to transfer assets of all accounts to the ETF.
  • Seed Date (the night prior to launch) all of the securities are valued based on closing prices of the market and an initial NAV of the ETF is struck – this number is typically divided by $25 (the NAV per share) to create the initial shares of the ETF.
  • Proportional shares of the ETF are sent back to each SMA account, accordingly.
  • Launch day – your ETF is up and running and ready to trade!

Some tactical considerations on tax-free ETF conversions from SMAs:

  • Ignore IRAs – no tax benefit and better to “save” those assets and have them trickle in for flows into the fund
  • Find a rep with your current custodians to help drive the conversion – this takes some massaging
  • Get a tax opinion for your shareholders to rely on that the conversion is tax-free

A final reminder: starting an ETF is not easy or cheap

ETF conversions can be a highly valuable tool for fiduciaries and asset managers that need help managing low-basis stock portfolios, efficiently. However, before leaving the comfortable world of “sticky/profitable” SMAs, “high FCF legacy” mutual funds, or “2/20 high fee” hedge fund structures, one should consider reading our piece on setting up an ETF. When you enter the ETF business you enter what Eric Balchunas deems the “ETF Terrordome.”

Please ask yourself the following questions before considering a move into the ETF business:

  • Are you prepared for extreme competition?
  • Are you prepared for 100% transparency?
  • Are you prepared for a high fixed-cost business?
  • Are you comfortable with losing money for potential years on end until you reach critical mass?
  • Are you masochistic and/or insane?

If you answered, “Yes,” to all the questions above, you should reach out and strike up a conversation via the contact form below:

Print Friendly, PDF & Email

References[+]