Converting Mutual Funds to Exchange Traded Funds

[MarieIG]

Hello All,

I have an account at Vanguard and have been considering converting my index mutual funds to the coordinating ETFs.

Is there any downside to doing this? These are held within IRAs.

(I am retired am not buying mutual funds/ contributing to an IRA on a monthly basis anymore.)

Does it matter whether I do the conversions when the market is on an upswing or downswing, or it doesn't matter. (I don't think that it should but maybe I'm missing something.)

Is this a simple matter of clicking on exchange funds in the brokerage account.

Feedback is appreciated.

Thank you.

 

[OldShooter]

In business, deals can be difficult or can even blow up when the participants in the deal have conflicting priorities. If I am one of two companies pursuing an opportunity, my priority may be to develop a long term customer and my partner company be intent on rape and pillage. That is a recipe for pricing and operational problems.

This is always in the back of my mind when I look at ETFs. The problem is "authorized participants." (https://www.investopedia.com/terms/a/authorizedparticipant.asp) Effectively this is a third person at the table with me and the ETF manager. This third person has no loyalty to me and only limited loyalty to the ETF. So, for example, when markets are dropping quickly, an authorized participant may decide to sit on its hands rather than create ETF shares where the time, maybe just milliseconds, could give him an inventory loss. There have been reports during recent market drops of ETF NAVs values diverging from quotations of their components. Could this become an issue? Seems unlikely because it is a short-term phenomenon. But that third person at the table makes me nervous. So I tend to prefer conventional mutual funds.

The advertised advantages of ETFs like intra-day trading and (IIRC) fewer capital gains distributions, are of no intereste to me because I am not a trader and our equities are held in tIRAs and Roths.

 

[Alan]

I converted my index MFs to ETFs a few years ago because they “report into HMRC” and as such are treated as regular equity funds for the much lower tax rates, and not as PFICs.

This was in a taxable account and there were zero tax consequences, the resulting value of the new ETFs being identical to the MFs they were transferred from so I don’t really think it matters when in the market cycle to do this.

 

[MarieIG]

Thank you both. I'm reading through Old Shooter's attachment.

 

[MichaelB]

Vanguard ETFs have slightly lower expense ratios compared with the corresponding mutual fund. ETFs have a tax advantage, but that is of no benefit when it’s in a tax deferred account.

An ETF can have a market price that deviates from its net asset value, especially at times of high volatility and market stress. These differences tend to be very short lived (minutes, perhaps a few hours) but it is important to be aware of them. This happened on a large scale during the flash crash of 2010, for example. ETFs that are very liquid are less likely to see differences between the NAV and market price.

I also did a conversion of a Vanguard fund to ETF in a taxable account. The cost basis didn’t carry over so I had to figure it out myself, but that doesn’t matter in a tax deferred account. During the flash crash I did invest in a Vanguard ETF (VIG) and got around a 14% discount. Never before or since …

 

[Markola]

Jack Bogle was vocally against Vanguard going into ETFs. His biggest concern was that they encouraged active trading. Also, our assigned Vanguard advisor could have put our tax advantaged funds in either ETFs or mutual funds and chose 100% mutual funds, so there’s that data point.

 

[TheWizard]

I hold both MFs and ETFs in my Vanguard accounts: Roth IRA and taxable. The MFs are mostly historical, before I warmed up to using ETFs.

I put a few thousand dollars into my taxable account each month and enjoy using limit orders to get a good price.

I suppose I could convert my admiral class MFs to ETFs, but I don't want to risk a record keeping screwup on cost basis or holding length...

 

[MarieIG]

Vanguard ETFs have slightly lower expense ratios compared with the corresponding mutual fund. ETFs have a tax advantage, but that is of no benefit when it’s in a tax deferred account.

An ETF can have a market price that deviates from its net asset value, especially at times of high volatility and market stress. These differences tend to be very short lived (minutes, perhaps a few hours) but it is important to be aware of them. This happened on a large scale during the flash crash of 2010, for example. ETFs that are very liquid are less likely to see differences between the NAV and market price.

I also did a conversion of a Vanguard fund to ETF in a taxable account. The cost basis didn’t carry over so I had to figure it out myself, but that doesn’t matter in a tax deferred account. During the flash crash I did invest in a Vanguard ETF (VIG) and got around a 14% discount. Never before or since …

Is there a way to be aware of this while it is ongoing, or is that something one might learn only afterwards? TIA

 

[MarieIG]

Jack Bogle was vocally against Vanguard going into ETFs. His biggest concern was that they encouraged active trading. Also, our assigned Vanguard advisor could have put our tax advantaged funds in either ETFs or mutual funds and chose 100% mutual funds, so there’s that data point.

Did he/she explain why?

 

[Exchme]

...I also did a conversion of a Vanguard fund to ETF in a taxable account. The cost basis didn’t carry over so I had to figure it out myself, but that doesn’t matter in a tax deferred account. …

When we did our switch to ETFs at Vanguard, the cost basis did carry over, it just took a couple of weeks. Your case sounds like a glitch. The only other possibility I can think of was that if your investments went back prior to 2012. They weren't required to keep the information before then, but whatever data they had, should transfer. In taxable, having no cost basis information could be a serious headache to figure your taxes when it's time to sell.

 

[racy]

I'm retired. I own mutual funds and have automatic monthly sales setup for income. You can't do that with ETFs

 

[MichaelB]

Is there a way to be aware of this while it is ongoing, or is that something one might learn only afterwards? TIA

The only way to see this happening in real-time is by tracking the market price of the ETF and comparing it with the benchmark or broader market.

ETF providers are required to share this information with you. On the Vanguard ETF page you can scroll down and look for a section titled “premiums and discounts”. A premium is when the ETF market price is above the net asset value (NAV), a discount is when the price is below the NAV. For example, the Vanguard ETF VIG traded at a 0.4% premium twice last year. That’s a pretty big difference. Will this impact you in some way? Probably not, but for this ETF, that 0.4% represents about 5 years of savings of the lower ETF expense ratio.

The most important thing to look at is the ETF liquidity. How many total $ are invested in the fund and how many shares are traded on average per day. The bigger the fund and the more shares traded, the less likely the market price will deviate from the NAV. For example, VIG has >$60B in assets and trades >1M shares per day, so I would expect the premiums and discounts to be limited and short lived.

 

[MichaelB]

When we did our switch to ETFs at Vanguard, the cost basis did carry over, it just took a couple of weeks. Your case sounds like a glitch. The only other possibility I can think of was that if your investments went back prior to 2012. They weren't required to keep the information before then, but whatever data they had, should transfer. In taxable, having no cost basis information could be a serious headache to figure your taxes when it's time to sell.

Thanks, that’s probably it, I recall originally investing in the mutual fund around 2010, just as the recovery was picking up.

 

[MarieIG]

The only way to see this happening in real-time is by tracking the market price of the ETF and comparing it with the benchmark or broader market.

ETF providers are required to share this information with you. On the Vanguard ETF page you can scroll down and look for a section titled “premiums and discounts”. A premium is when the ETF market price is above the net asset value (NAV), a discount is when the price is below the NAV. For example, the Vanguard ETF VIG traded at a 0.4% premium twice last year. That’s a pretty big difference. Will this impact you in some way? Probably not, but for this ETF, that 0.4% represents about 5 years of savings of the lower ETF expense ratio.

The most important thing to look at is the ETF liquidity. How many total $ are invested in the fund and how many shares are traded on average per day. The bigger the fund and the more shares traded, the less likely the market price will deviate from the NAV. For example, VIG has >$60B in assets and trades >1M shares per day, so I would expect the premiums and discounts to be limited and short lived.

Thank you very much for the detailed explanation Michael. I will go look for the premium and discount info.

 

[Sunset]

.....

An ETF can have a market price that deviates from its net asset value, especially at times of high volatility and market stress. These differences tend to be very short lived (minutes, perhaps a few hours) but it is important to be aware of them. This happened on a large scale during the flash crash of 2010, for example. ETFs that are very liquid are less likely to see differences between the NAV and market price.

.....…

True, because they act like stocks, just as stocks can deviate drastically from their intrinsic value when people bid them up or panic sell. Prices will vary wildly. Nothing sinister going on.

And I've learned from Freedom56 that bonds can suddenly and wildly vary in price for a short while.

 

[Closet_Gamer]

I use a mix of MF's and ETFs.

But I do have a question:

I'm aggressive about using highly appreciated shares to fund charitable contributions through a Donor Advised Fund.

When I look at doing donations, my ETF purchases are always shown with a cost basis at the price at which I purchased the ETF. So if I bought 100 shares of an ETF for $10 in 2018 and another $100 shares for $20 in 2019, I can select the 2018 shares to get the high tax deduction.

When I do the same for my mutual fund shares, my broker (Schwab) reports the cost basis of my mutual fund shares as the average of all my outstanding shares and their purchase price. Using the above example but with a MF, rather than seeing the 2018 at $10 and the 2019 at $20, my MF would show 2018 at $15 and 2019 at $15.

As such, I've tended towards ETFs because they set up better charitable tax management in the future.

Question: Is that actually how cost basis for MFs work or is that some weird data presentation thing from Schwab?

Thanks.

 

[audreyh1]

Is there a way to be aware of this while it is ongoing, or is that something one might learn only afterwards? TIA

In the Vanguard funds I don’t see any benefit in converting to an ETF unless you are trying to take advantage of price swings during the day. And that’s the same situation prone to the market price deviating from underlying values - that can happen during the conditions of panic and high market volatility not to mention flash crashes.

The Vanguard mutual funds get the same low cap gains distributions benefit as their equivalent ETF, and in a tax-deferred account it doesn’t matter anyway.

So what are you trying to accomplish?

 

[retired1]

I'm retired. I own mutual funds and have automatic monthly sales setup for income. You can't do that with ETFs

Nice. That's exactly what's keeping me to go to ETFs. They require buy/sell effort hence the emotions come into play

 

[JoeWras]

I use a mix of MF's and ETFs.

But I do have a question:

I'm aggressive about using highly appreciated shares to fund charitable contributions through a Donor Advised Fund.

When I look at doing donations, my ETF purchases are always shown with a cost basis at the price at which I purchased the ETF. So if I bought 100 shares of an ETF for $10 in 2018 and another $100 shares for $20 in 2019, I can select the 2018 shares to get the high tax deduction.

When I do the same for my mutual fund shares, my broker (Schwab) reports the cost basis of my mutual fund shares as the average of all my outstanding shares and their purchase price. Using the above example but with a MF, rather than seeing the 2018 at $10 and the 2019 at $20, my MF would show 2018 at $15 and 2019 at $15.

As such, I've tended towards ETFs because they set up better charitable tax management in the future.

Question: Is that actually how cost basis for MFs work or is that some weird data presentation thing from Schwab?

Thanks.

Most brokerages default to average cost basis. You have a choice to make it be Specific ID, but you usually have to choose to do so.

Also, if you have already sold, you probably can't do Specific ID anymore.

Common advice around here is to set up your MF accounts to display specific ID when you begin. Then you can pick and choose lots to donate, sell, tax loss harvest, etc.

 

[OldShooter]

True, because they (ETFs) act like stocks, just as stocks can deviate drastically from their intrinsic value when people bid them up or panic sell. Prices will vary wildly. ...

Err ... Actually ... No. What you are describing is closed end funds (https://www.investopedia.com/terms/c/closed-endinvestment.asp). Many threads here have given their lives discussing CEFs.

Conventional mutual funds and ETFs are open-end funds (https://www.investopedia.com/terms/o/open-endfund.asp). The idea of an open-end fund is that as people buy and sell shares in the fund, the sponsor buys and sells fund holdings according to its portfolio rules. Thus the buyer or seller of fund shares has essentially no effect on the fund price. With conventional mutual funds, this is not a hard thing to implement. After every market close the fund sponsor calculates a Net Asset Value (NAV) and that day's buys and sells are executed at that price. (The sponsor actually maintains some cash so that they don't have to go into the market with every shareholder transaction. Netting shareholder buys and sells also makes life easier.)

ETFs, where the price constantly fluctuates during the day, are a lot harder to consistently price at NAV. That is where the authorized participants come in. (See my post 2 and https://www.investopedia.com/terms/a/authorizedparticipant.asp). These folks have a sort of special license to minimize the any discrepancy between the posted price of the fund and the real NAV based on adding up the stocks that the fund holds, then taking action on discrepancies. It's a sort of special kind of arbitrage. When things get a little crazy and the authorized participants' fear losing on their arbitrage transactions, then they may choose to sit on the sidelines. The degree and duration of any divergence is impossible to predict and hard to know (from outside) as it is happening.

 

[Closet_Gamer]

Most brokerages default to average cost basis. You have a choice to make it be Specific ID, but you usually have to choose to do so.

Also, if you have already sold, you probably can't do Specific ID anymore.

Common advice around here is to set up your MF accounts to display specific ID when you begin. Then you can pick and choose lots to donate, sell, tax loss harvest, etc.

Super helpful. I will ask my broker to change the setting. I haven't donated any of the MF shares for the reason noted...I always had ETF shares that were much better to donate so I used those.

Thanks!

 

[MarieIG]

In the Vanguard funds I don’t see any benefit in converting to an ETF unless you are trying to take advantage of price swings during the day. And that’s the same situation prone to the market price deviating from underlying values - that can happen during the conditions of panic and high market volatility not to mention flash crashes.

The Vanguard mutual funds get the same low cap gains distributions benefit as their equivalent ETF, and in a tax-deferred account it doesn’t matter anyway.

So what are you trying to accomplish?

I was interested in exploring the pros and cons of a potential exchange due to the ability to submit limit orders.

At some point, I will want to convert the funds in the traditional to a Roth. Thus far, I have only converted cash in the settlement account.

 

[MarieIG]

For the time being, I am leaving the funds in my IRAs alone. I converted a little cash to my Roth today (as per my pre-planned schedule) and will put in a limit order for a little more VIG, if and when there is a drop. If not, que sera sera (a la Doris Day).

If there is a significant drop from here, I will convert some funds directly. No, I can't time the top and the bottom, but I can get a discount from the highs. Maybe.

 

[RetMD21]

Super helpful. I will ask my broker to change the setting. I haven't donated any of the MF shares for the reason noted...I always had ETF shares that were much better to donate so I used those.

Thanks!

At Vanguard you can DIY for sales by selecting specific shares from the drop down. . I sold some municipal bond fund shares. I would have been just as happy with HIFO but I couldn't easily tell how many shares I could sell at a loss. It would be great if they had a slider that would tell you the net gain loss for x% shares.

 

[TheWizard]

For the time being, I am leaving the funds in my IRAs alone. I converted a little cash to my Roth today (as per my pre-planned schedule) and will put in a limit order for a little more VIG, if and when there is a drop. If not, que sera sera (a la Doris Day).

If there is a significant drop from here, I will convert some funds directly. No, I can't time the top and the bottom, but I can get a discount from the highs. Maybe.

Ok, fine.
But converting mutual funds to ETFs is a completely different thing from doing Roth conversions.

I use limit orders to buy additional ETF shares but I'm not sure how one could use limit orders to do Roth conversions. I never did...