Applying for ETF Share Class Exemptive Relief

At Dimensional, we say, “Do the right thing, do it the right way, and do it right now.” Doing the right thing means sitting on the same side of the table as the financial professionals we work with so their needs drive our firm’s priorities. Doing it the right way means investing using a rules-based but flexible approach that goes beyond indexing. And doing it right now means what it says.

Many advisors and institutions continue to ask for additional investment strategies to be efficiently delivered as both mutual funds and ETFs. That is why, with unanimous support from our mutual fund board, we have decided to formally apply to the SEC for ETF share class exemptive relief. If the SEC grants our requested exemptive relief, we expect to work closely with our mutual fund board to evaluate, on a fund-by-fund basis, which of our mutual funds are appropriate candidates to offer an ETF share class.

How Dimensional manages ETFs uniquely positions us to do this the right way for current and future mutual fund shareholders. For over four decades, our mutual funds have used a daily approach to portfolio management that targets securities with higher expected returns and robustly manages risks and costs. In 2020, we brought this approach to ETFs and enhanced it.

We developed a set of custom create/redeem basket methodologies, and the infrastructure to support them, that we use for low-cost and tax-efficient daily ETF rebalancing. These methodologies consider authorized participant (AP) trading costs, which helps us manage the bid-offer spreads of our ETFs. We innovated so that the create and redeem activity resulting from secondary market trading activity of an ETF can benefit all shareholders of the ETF.

We believe our innovative approach to custom baskets provides a venue for efficient in-kind rebalancing through the ETF share class that would benefit shareholders of both mutual fund and ETF share classes through lower portfolio transactions costs and increased tax efficiency.

Additionally, if the SEC grants our requested exemptive relief, mutual fund shareholders of any funds that offered an ETF share class could exchange their mutual fund shares for ETF shares, potentially without incurring transaction costs or taxes, to access the same investment approach they appreciate today in an ETF wrapper.

Our mutual funds also uniquely position Dimensional to offer ETF share classes the right way for ETF shareholders. In general, our mutual funds are characterized by efficient use of investor cash flows as part of a daily rebalancing process, low amounts of uninvested cash, low brokerage and other implicit trading costs, and tax efficient portfolio management.

We believe shareholders in an ETF share class could benefit from the daily cash flows of shareholders in the mutual fund. Cash flows can be used for the dual purpose of strategically rebalancing the fund while allowing for additional flexibility in the use of custom create and redeem baskets. This flexibility can lower total portfolio transaction costs.

In our view, ETF share class shareholders could also benefit from the existing broad client base and track record of the mutual fund share class. These benefits include scale through immediate security level diversification, reduced other expenses, and increased security lending revenue.

In our view, ETF share class exemptive relief would allow us to continue to innovate so that mutual fund cash flows, combined with the secondary market trading activity of an ETF share class, would lead to cost efficiencies for all shareholders of the fund.

About five years ago, our clients began frequently asking for our strategies in an ETF wrapper. The rules and infrastructure used to govern and manage ETFs were mostly designed for index funds and not well suited to our investment approach. In September 2019, the rules changed.

Rule 6c-11 (the “ETF Rule”) became effective and provided the potential for significant improvements in the ETF industry. It did not, however, permit ETF share classes. In its Adopting Release, the SEC noted that the cash flows associated with mutual fund classes could generate excess costs and tax burdens for shareholders of the ETF class. In our view, any such concerns are more applicable to an index strategy that does not use cash flows optimally, and our approach to investing should mitigate these issues.

In 2019, we planned to bring best-in-class standalone ETFs to the market, fully convert some of our mutual funds to ETFs, and, for other mutual funds, seek ETF share class exemptive relief to provide shareholders the choice to convert.

We built the infrastructure, systems, and connections to APs that would allow us to make full use of the ETF Rule. In November of 2020, a little over one year after the ETF Rule was adopted, we launched a set of standalone ETFs rooted in Dimensional’s investment approach.

If new regulations, technologies, or research findings allow us to improve how we invest, we will use them. At the time, we managed seven mutual funds that explicitly considered the impact of federal income taxes on returns. Our new infrastructure and systems allowed us to bring the same quality portfolio management to these funds in an ETF wrapper. And in an ETF wrapper, the funds would gain an additional tool to manage the impact of federal taxes.

Before 2020, mutual fund-to-ETF conversions were unheard of, but in 2021 and 2022 we effectuated almost $40 billion of mutual fund-to-ETF conversions across seven funds—the largest in the industry. We targeted for conversion our tax-managed and tax-advantaged funds to ETFs because over 99% of the shares in these funds were held in taxable accounts, which made the tax-free reorganization particularly valuable to investors in our funds.

Our other funds are held by a mix of taxable and non-taxable accounts. For these funds, rather than a full mutual fund-to-ETF conversion, we wanted to give shareholders the choice to exchange to an ETF share class if they deem it best for them.

To accomplish this, we engaged with the SEC staff in 2019 and 2020 to discuss ETF share class relief, which the SEC has granted to just one firm: Vanguard, for its index funds beginning in 2000. These conversations improved our understanding of the SEC staff’s concerns, and lead us to believe that we can offer an approach that would alleviate those concerns.

The world has evolved in recent years. Many active-transparent ETFs are coming to the market, including 31 managed by Dimensional (with more likely to come). We have shown our approach can be implemented equally well in a mutual fund or ETF wrapper. Finally, structures like ETF share classes already exist in non-US markets. For example, Irish and Luxembourg UCITS offer mutual funds with ETF share classes, and mutual funds in Australia provide investors with dual access points (listed and unlisted). We believe the SEC should allow similar structures and not leave US investors behind.

We say at Dimensional, “Do the right thing, do it the right way, and do it right now.” Listening to the needs of the financial professionals we work with is our right thing. Advocating, yet again, for ETF share classes is our right way. SEC, please let’s get it done right now.

Exemptive Relief

Mutual Fund Share Class Structure 

Making Cash Flows Count